Regulatory Tools – Key to Market Efficiency

8/13/2019 Regulatory Tools Key to Market Efficiency

1/37Electronic copy available at: http://ssrn.com/abstract=1915116

Regulatory ToolsKey to Market Efficiency

V. Shunmugam, Niteen Jain and Nazir Ahmed Moulvi

(Published in book titled Research in Financial Derivatives by Pondicherry University, India)

Mankinds quest for markets that can meet the challenge of an unpredictable future with limitedresources ended up in derivative markets, which provides all the stakeholders equal access to

spread their risks thinly into the economy. Until the negative impact of the financial crisis on

them was experienced, the boom in the business of exchange-traded marketplaces blinded both

regulators and stakeholders in developed economies from possible pressure points that these

markets could come under, leading to undesirable impact on the real economy. Post-crisis,

regulatory tools of derivative markets have found a renewed attention. Though they are critical

to maintaining market discipline and its healthy development, the tools can also be a big

hindrance to the normal functioning of markets if not used judiciously. Therefore, a judicious

use of an optimal mix of various regulatory tools would not only help these markets to

efficiently function but also help effectively serve their stakeholders. Also, real-time, one-point

coordination among all regulators at the international level rather than regulation in

isolation across scattered geographies maybe the panacea to keep healthy the world of

interconnected financial markets.

With the progress of civilisation, as

humans began specialising in what they

produced, markets emerged to transact

goods and services among specialising

communities (usually located in

geographically diverse regions) using a

common medium called money a

currency note backed by credible public

institutions such as treasuries of

kingdoms or by governments that have a

long history of autonomous existence

from mankinds journey from the

autocracy that prevailed few centuries

ago to the democracy of modern days1. In

V. Shunmugam is Chief Economist and Niteen

Jain and Nazir Ahmed Moulvi are Senior

Analysts with the Multi Commodity Exchange of

India Ltd., Mumbai. Views expressed here are

personal.

the process, much had been left to the

players in markets to value these goods

and services appropriately assuming that

these markets and, hence, the players in

them operate in the public interest to

fully converge the forces of demand and

supply in a fairly competitive situation.

However, in reality, in regular market

operations, not only the convergence gets

limited to the geographical area but also

the structural rigidities prevent them from

developing into efficient markets. Also

with increasing demand (due to

population, its income, etc) and limited

1Kinnaird, Percy Evolution of Money

BiblioBazaar, LLC, 2009, ISBN

1113998970, 9781113998972


2/37Electronic copy available at: http://ssrn.com/abstract=1915116

supplies of resources to satisfy the same,

the producers, processors, and those in

the supply chain always needed a market

place where they would not only know

the price in advance but would like to

participate and lock in their future cost or

return expectations to bring in socio-

economic stability in respective

sovereigns.

Mankinds quest for markets that can

meet the challenge of unpredictable

future due to limited resources that would

support growing population and its needs

ended up in derivative markets that

provide equal access to stakeholders to

participate and spread the risks arising

out of such a situation thinly into the

economy. These markets came into being

to be accessed by a wide set of

stakeholders directly or indirectly,

predominantly for trading on the

underlying commodities during its early

stages of evolution. Later, trading wasextended to intangible asset classes such

as stocks, exchange and interest rates2.

Among these, commodities remain the

earliest derivatives market-traded asset

class, with derivatives in others which are

just about a couple of decades old. Given

their economic functions, the benefits

they are supposed to deliver to the real

economy, the amount of information that

2Swan, Edward J. Building the Global Market,

A 4000 Year History of Derivatives Kluwer Law

International; First edition (January 1, 2000),

ISBN-10: 9041197591

is needed to be converged into the

marketplace and its implications on the

future state of the economy and its

stakeholders, the leverage that they

provide to the participants, derivative

markets were not only more closely

monitored and supervised but were also

regulated using varied tools.

With the ingraining of the self-correction

mode of markets per the capitalistic

thinking that prevailed over during the

last half a century not only among the

regulators but also among the

policymakers and all stakeholders of

much of the western economies, some of

these regulatory tools were sparingly

used in few of their markets and few

other tools had almost sunk into oblivion.

Even, any effort on the part of regulators

to use various tools to control market

transgressions faced opposition from the

participants as being detrimental to the

functioning of organized and transparentexchange traded market places. This

could partially be attributed to the

principles-based regulations as they

prevail in US and UK markets compared

with the prescriptive rules-based

regulations as it exists in the emerging

markets.

The financial crisisan eye opener

Until the recent financial crisis and its

impact on the exchange-traded

marketplaces, the stakeholders and the

regulators basked in the glory of the

growth in their regulated exchange-traded

markets. Globalization and the free


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movement of capital across developed

and a few developing economies further

boosted volumes in the derivatives

markets of developed economies. The

boom in the business of exchange-traded

marketplaces blinded the regulators and

the stakeholders from possible pressure

points in the markets leading to their

undesirable impact on the real economy

making businesses suffer and, in some

cases, the stakeholders withdraw from

markets. Evidently though, the US

Commodity Futures Trading Commission

(CFTC) announced that its enforcementprogram filed 57 enforcement actions in

Fiscal Year (FY) 201014 percent more

than in FY 2009 and 42 percent more

than in FY 2008 (during the height of

financial crisis)3.

Thanks to US policymakers realisation

about the implications of a lax regulatory

policy regime, the senate swung in to

tighten the armoury of the regulators of0US markets. The Dodd-Frank Bill was

introduced to address the shortcomings in

the regulated markets and the arbitrages

that existed between the regulated and

non-regulated marketplaces. Though the

Bill was welcomed with cautious

optimism by most market players,

academicians and policymakers came out

in its support overtly. On the strength of

efforts put in to drafting and finalizationof the Bill and support from

3http://forexmagnates.com/cftc-increases-

enforcement-filings-by-14-in-2010/

academicians, SEC and CFTC, the key

regulators of exchange-traded

marketplaces for various underlying

financial assets have initiated the process

of development of comprehensive

regulations that will keep away the

organized exchange traded market places

from any unwarranted public criticism.

These regulations are aimed at preventing

risks to and from exchange-traded

marketplaces from its user stakeholders

or on the real economy and its

stakeholders. Thanks to the financial

crisis, policy makers and regulatorsacross the globe are also looking at a

common forum where coordination on

regulation could be discussed, ranging

from the politically charged G-20 forum

to the international institutional forums

such as IMF and BIS.

Of risks, derivative markets and

regulations

Here is an attempt to look at the basic

functions of exchange-traded derivatives

markets, risks arising out of their

functioning or posed to their efficient

functioning and the regulatory tools used

to contain them. In doing so, an attempt

has been made to collate regulatory

tools/practices and ways of their use by

various global regulators had been

examined in this attempt. Having said, itis notable that regulatory tools in

derivatives markets are double-edged

swords that can well prove lethal to the

normal functioning of markets if not used

judiciously. While regulatory


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tools/practices would have local cultural

or micro-market structure assumptions

behind them, in the light of increasing

interconnectedness of markets and hence

easy spread of information among them,

regulatory tools or practices have been

examined from their perspective of

suitability for the sustenance and long-

term healthy existence of exchange-

traded derivative markets to deliver its

benefits to the real economy.

Meanwhile, the inter-connectedness of

the derivatives markets for various asset

classes and markets across various

geographies leaves much for the market

participants to arbitrage regulatory

regimes4; especially if there exists a

disconnect between the business interests

of the exchanges as SROs and the

regulators besides between regulators of

various asset classes and regulators from

across the globe. Such conditions further

requires that the regulators would notonly have to work in tandem with others

within their own geography and across

interconnected geographies but also have

a deeper understanding of the cash and

other inter-connected OTC markets. With

different regulatory structures that exist

across economies, it is also necessary that

4

Article titled Sen. Dodd Concerned AboutGlobal Regulatory Arbitrage, Particularly in

Derivatives Area.

http://financialreform.wolterskluwerlb.com/2010/

08/sen-dodd-concerned-about-global-regulatory-

arbitrage-particularly-in-derivatives-area.html

Accessed on Oct 19, 2010.

there exists a global forum wherein issues

related to financial stability arising out of

the exchange traded derivative markets,

functioning of the financial sector, and its

implications for the real economy could

be discussed and ironed out. Such a

forum could also be replicated at the

national level to ensure coordination at

the local level among regulators across

various asset classes and the central

banks before issues could be examined at

the global level. The recent

establishment of Financial Stability

Development Council through anexecutive order of the Government of

India signifies the same in favour of a

body for inter-market coordination within

the Indian economy. It could apply well

to economies with the varied regulators

in the financial sector with markets that

are interconnected in terms of

participants. Even, within those nations

adopting a single regulator model for the

financial sector, this signifies the need forincreased coordination among different

arms of the regulators looking into

various asset classes and at times the

underlying cash markets by making

formal structure for the same to function

under given principles along with the

central bank as the pivot. Keeping this

aside, issues in inter-market and inter-

global institutions have been highlighted

in the paper for appropriate cooperation

and coordination among them to help

resolve problems in market irregularities

at their origin.
http://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.htmlhttp://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.htmlhttp://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.htmlhttp://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.htmlhttp://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.htmlhttp://financialreform.wolterskluwerlb.com/2010/08/sen-dodd-concerned-about-global-regulatory-arbitrage-particularly-in-derivatives-area.html


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Exchange Traded Derivatives

markets Roles, Risks and

Regulations

During the last three decades, derivatives

have developed into an important class of

global financial instruments that are

central to the existence of the transparent

and exchange traded market places

helping economic stakeholders manage

their risks in an era of rapid information

flow. By being transparent, and

regulated, exchange platforms in which

these derivatives are traded were alsoexpected to provide advance signals to

policy makers to help them effectively

decide on policies for economic stability

and hence social and political stability.

Simultaneously, the opaque and OTC

traded market places that have catered to

customisation needs of market

participants also remained no stranger to

innovations in financial derivatives5, the

only difference being unregulatedinnovation leading to the development of

complex derivative products often to the

benefit of their originators6 rather than

5Article titled OTC Derivatives Don't Need Fixing

byMenachem Brenner. Accessed on Oct 19 2010;

http://www.forbes.com/2010/05/11/finance-

regulation-derivatives-opinions-contributors-

menachem-brenner.html

6Steven L Schwarcz, Rethinking the disclosure

paradigm in a world of complexity (University of

IllinoisLaw review Volume 2004).

http://www.securitization.net/pdf/content/Schwar

cz_Rethinking_04.pdf

end-users. This is proven by the fact that

no other class of financial instruments

had experienced as much innovation as

OTC derivatives as a class. Product and

technology innovation, together with

competition, had led to a noticeable

growth in the exchange-traded

derivatives segment as well.

Electronification, leverage as it exists in

the derivatives market, and the robust

clearing mechanisms had not only

provided easier access across asset

classes to a wide range of participants but

also had its own costs and benefits.However, benefits of public regulation

and transparency of a market place

always outweighed the risks in the case

of the exchange-traded derivative

segment. On the other hand, over a

period of time, these benefits seemed to

have overwhelmed the regulators from

the potential risks arising out of

individual or collective irrationality of

participants and, hence, the risks to andfrom the exchange traded market places.

This led to the gradual slackening of

regulatory policies across market places,

especially in developed markets. An

attempt has been made here to look

through the possible effects of individual

or collective irrationality, its impact on

the basic functions that exchange-traded

derivatives are supposed to perform in an

economy and the role of regulatory tools

from an inter-asset class and cross-

geographic perspective.
http://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.htmlhttp://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.htmlhttp://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.htmlhttp://www.securitization.net/pdf/content/Schwarcz_Rethinking_04.pdfhttp://www.securitization.net/pdf/content/Schwarcz_Rethinking_04.pdfhttp://www.securitization.net/pdf/content/Schwarcz_Rethinking_04.pdfhttp://www.securitization.net/pdf/content/Schwarcz_Rethinking_04.pdfhttp://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.htmlhttp://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.htmlhttp://www.forbes.com/2010/05/11/finance-regulation-derivatives-opinions-contributors-menachem-brenner.html


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Any text book on derivative markets

would tell us that exchange-traded

derivatives primarily perform two roles:

(1) Price Discovery Discovering pricesor exchange rates or yields on bonds in

advance through collective expectations

of participants

(2) Price Risk Management- Allowing

economic agents to participate on their

platforms to lock in their cost or return

expectations to help provide price

stability to its consumers.

An independent or a government

regulator always supervised and

regulated the exchange traded market

places so that they function perfectly to

perform its functions flawlessly and that

their working does not impact the real

economy in ways they are not intended

to. In a nutshell, regulation in exchange-

traded markets makes sure that:

Prices discovered for futuredelivery of the underlying are best

reflectors of the future situation as

it would prevail in the cash

markets for the underlying asset

class.

Businesses and individuals areable to manage their risks in acost-effective way and the risks

spread as thinly as possible within

the economy.

Reduces market instability and,hence, financial, economic, and

political instability.

While the risks in derivatives markets canbe further segregated, which have beendetailed in a number of papers, little hasbeen said of the many regulatory toolsused by these markets that aim to controlany aberrations in the functioning ofthese markets caused by instances such asindividual/collective market irrationality.

Therefore, in this paper we tried toexamine in detail the role played byregulators and the tools employed inselected derivatives market spread acrossthe globe (in both developing anddeveloped markets) and also across theasset classes (commodities, securities,currencies, etc) and churn out theregulatory best practices which wouldmake the best use of these double-edgedtools. Provided below is a graphicalrepresentation of the functions of thederivatives market. We then illustrate therisks that can arise in the way of marketefficiently delivering its functions. This is

followed by a look at the tools that areavailable with the exchanges to eliminatesuch risks.


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Risks to and from Derivatives Markets


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Derivatives Regulation Worldwide

and across Asset Classes

Globally, across the asset classes, toprevent the conversion of potential risksinto actual risks, regulations onexchange-traded derivatives trading arefirst imposed at the exchange level i.e. byexchanges themselves, acting as self-regulatory organisations to ensureintegrity of the respective markets. At thenext and external level, regulations arelevied by an independent regulatory bodyi.e. a derivatives market regulator. Insome countries, an association of marketparticipants, such as the National FuturesAssociation (NFA) in the US, also plays

a self-regulatory role to regulate and

monitor intermediaries and marketinfrastructure institutions with regard totheir adherence to regulations. And inothers, the quasi or governmentalregulatory agencies set the rules for playin the markets and watch the markets

from a distance for appropriate actionwhen it perceives risks from it or to itsfunctioning. Table 1 gives a peek atvarious regulatory bodies and exchangesregulating the derivatives trading incommodities, currencies and securities insome developed as well as developingeconomies which are being examined toprovide a comparative view of regulatorytools for various asset classes and that ofvarious regulators.

Table 1: Regulators and exchanges in derivatives trading worldwide and across asset classes

Asset class Developed Economies Developing Economies

Country Exchange Regulator Country Exchange Regulator Country Exchange Regulator Country Exchange Regu

ommodityNon agri)

US CME CFTC Japan TOCOM MITI India MCX FMC China SHFE CS

ommodity(Agri)

US CME CFTC Japan TGE MAFF India MCX FMC China DCE CS

Currency US CME CFTC Korea KRX FSS India MCX-SXSEBI &

RBIBrazil BM&F CV

Stock

IndexUS CME CFTC Japan OSE JFSA India NSE SEBI China CFFEX CS

ote the above table shows one of the exchange operating in its economy, however there could be other exchanges as well.MEChicago Mercantile Exchange; CFTCCommodity Futures Trading Commission; TOCOMTokyo Commodity Exchange; TGETokyo Grainxchange; KRXKorea Exchange; FSSFinancial Supervisory Service; OSEOsaka Stock Exchange; MITIMinistry of International Trade and Indu

MITI; MAFFMinistry of Agriculture, Forestry and Fisheries; JFSAJapan Financial Services Authority; MCX- Multi Commodity Exchange of India;MCX-SXMCX Stock Exchange; NSENational Stock Exchange; FMCForward Market Commission; SEBISecurities Exchange Board of India; R

eserve Bank of India; SHFEShanghai Futures Exchange; DCEDalian Commodity Exchange; BM&FBolsa de Valores, Mercadorias e Futuros; CVomisso de Valores Mobilirios; CFFEXChina Financial Futures Exchange; and CSRCChina Securities Regulatory Commission

The severe global financial crisis of2008-2009 has put derivativesregulation a hot subject of talks, debatesand conversation in various economic,

regulatory and market circles across theglobe. It became a topic of discussioneven in the international bodies such asG-20, etc. Moreover it is the OTCderivatives markets, which are oftenbeyond the conventional regulatoryframework, that have come under intensescrutiny of policymakers owing to

lingering doubts of transparency andrisks in OTC derivatives markets.Interestingly, it was the counterpartydefaults in CDS OTC markets in the US

that triggered the collapse of largefinancial players in the past crisis that ledto severe stress throughout the globalfinancial system. In lieu of inherentweakness and lack of regulation in OTCmarket, the exchange trading platformplaced under regulatory framework,guarded by a central clearing house to


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counterparty default risk, got viewed as amore competent and efficient alternativeto the OTC platform for derivativestrading. Hence, among the policy circlesin countries with predominant OTCmarkets have pushed for trading OTC

products on exchange traded platforms orat least through clearing houses (to startwith) to mitigate possible counterpartyrisks and to bring in transparency aboutlooming risks in the markets forappropriate policy mitigation.Notwithstanding, the prime reasonbehind these calls are the efficientregulations that have been enforced bythe regulators on the exchange tradedderivatives and the robust clearing

mechanism that tackles counterpartyrisks. This is not to mention thatexchange traded markets were beyondpublic scrutiny, thanks to the commoditymarket volatility and oil market volatilityin particular, exchange traded derivativemarkets are also being looked into byvarious regulators looking to strengthenboth their price discovery mechanism andthe risk management efficiency.

Regulatory practices on the overall seemto converge among the developingnations and developed nations butkeeping them poles apart regarding theexistence of it or the use of it in theirrespective exchange traded markets. Theprocess of globalization created a new setof asset classes which are global to betraded in both the markets to discover thelocal prices discounting for both theglobal and local fundamentals. Thanks to

opacity in the developing markets andwider participation in developed markets,there existed not only a wider divide inregulation of markets till financial crisisbut also that none complained about themarkets in developed economies or theirregulation. As the crude pricesskyrocketed, it prompted policy makers

to ponder upon issues related to it. Itresulted in the debate of regulatorydivergence in global market places andthe need for a global mechanism that canwork not only to bring about convergencebut also to provide a platform for ironing

out issues raised by respective nationalstakeholders. For example, any attemptto use such tools as it existed in the pastor as it is followed elsewhere werecriticised by market stakeholders as beingretrograde to the healthy functioning ofthe derivatives markets. To quote, therecently proposed CFTC rule on theenforcement of position limits inexchange traded US commodityderivatives market had created a uproar

against it among the participants in theUS commodity markets. Interestingly,such limits have already been in practicein commodity derivatives market ofdeveloping countries for reasons otherthan the purpose of efficient pricediscovery as developed nations in most ofthe global asset classes are price takers.Detailing the various regulatory modelsin different nations across the assetclasses or more specifically detailing the

scope and variety of various regulatorytools employed by the differentregulators presents an interestingcompare and contrast case on theregulations across different economies.Hence, on similar lines, regulatory toolsacross various global exchanges and assetclasses are detailed down in the paper.As we examined this area of regulatorytools and practices, dearth of literaturesubstantiating the existence or their use

amazed us. But the vast differencesamong the developed and developingnations made it curious to understand itfrom the perspective of potentialinterconnectedness of the markets andhence the need for global convergence inregulation of derivatives industry besides


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highlighting the same for further researchin academics.

Regulatory Tools Addressing

Risks to/from Derivatives Market

1.

MarginsMargins on derivative contracts play two

potential roles: one, protect against

defaults in fulfilling positional

obligations and two, provide a vehicle for

regulating volume, open interest, and

price behaviour (Tomek, 1985)7.

Derivatives are leveraged instruments but

offer returns equivalent to those of

trading in the cash market as theunderlying asset prices move up and

down. Thus, higher leverage incentivizes

traders to keep markets noisy. Noise in

the derivative market beyond limits not

only becomes unhealthy for the market

itself but also starts impacting the

underlying cash market and, in turn, the

interests of real economy stakeholders at

large. It makes a case for regulating

leverage to reduce not only unwantednoise but also financial risks in the

derivatives market. This is where the role

of margin both initial and mark-to-

market (MTM) margin mechanism

comes into play (the role of MTM will be

explained later).

Leverage is also a mechanism that helps

markets gather information by making

participation less burdensome and make

7Tomek, William G. Margins on Futures

Contracts: Their Economic Roles and Regulation,

the American Enterprise Institute for Public

Policy Research, Washington, D.C.

participants feel its expected impact in

the most disaggregated manner,

spreading the risks thinly among the

participants (stakeholders). It necessitates

that regulators manage leverage carefully

and not strangulate markets fromefficiently performing their task of

widening participation - collection of

information related to the fundamentals

of the underlying asset class

information driven discovery of prices as

well as spreading the risks arising out of

information entering marketplaces thinly

across various (heterogeneous) economic

stakeholders. In a nutshell, sterilize the

underlying asset class ecosystem of risks

by spreading it across to others who are

willing to share in return for the

information that they are passing into the

markets.

Margin requirements are used only as a

mechanism to prevent a trader from

defaulting, and adjusting the margins for

the market risk has no impact on trading

volume (Phylaktis and Aristidou, 2008)8.

Likelihood of a default due to margin

violation is a decreasing function of the

margin deposit and an increasing

function of the price limit. A safe system

would be the one that places the price

limit higher than the margin deposit so

that the margin deposit covers both the

price change and a possible further

adverse movement of the fundamental

8Aristidou, Antonis A. and Phylaktis, Kate,

Margin Changes and Futures Trading Activity: A

New Approach (January 1, 2008). Available at

SSRN: http://ssrn.com/abstract=1084104


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value unknown because the market is

closed (Longin, 1999)9.

As margins reflect the leverage that the

derivative market provides to its

participants, margins are adjusted to

reduce the leverage thereby reducing

incentives for creation of undue noise.

Since margin is pre-announced per the

derivative contract at the time of its

launch in market place, whatever interim

margins levied would be in addition to

the initial margin as announced per the

contracts traded in the respective

exchanges. The exchanges as Self

Regulatory Organizations (SROs) havevaried these margins per their perception

of noise or its measurement using VAR

(value at risk) methodology. While in

some markets (mostly in emerging

economies) margins are leviable from

both the sides by both the exchanges

and their regulators, in most markets,

worldwide, margins are managed mainly

by the exchanges based on their own risk

perception as SROs.

In the event of the contracts with same or

similar underlying asset trading on two

exchange platforms based in different

geographies, it leaves regulatory arbitrage

to be exploited in this world of

financially interconnected markets.

Participants would shift from a high-

margin platform to a low-margin

platform, thereby defeating the very

9Longin, Franqois M. Optimal Margin Level in

Futures Markets: Extreme Price Movements. The

Journal of Futures Markets, Vol. 19, No, 2. 127-

152(1999).

purpose behind the use of margins as a

regulatory tool to contain market

volatility provided the participation cost

remains the same. In such cases, it is

desirable that regulators intervene to

narrow down/close the arbitrage arisingout of differential treatment of the same

risk by different exchanges trading on

identical/similar products. Also, longer

the derivative contract gets traded, wider

and deeper participation is needed to

make information converge in

discovering the price while efficiently

delivering on its risk management

function. At times, it also happens across

geographies wherein exchange-traded

market places have identical/similar

products and are regulated by their

respective regulators. In such cases, it

warrants that there is a coordinated action

in the market place so that market

participants do not seek ways around

regulatory requirements and, thus, defeat

the overall objective behind use of this

regulatory instrument.

CFTCs recent attempt to reduce the

leverage in foreign exchange trading is a

clear case wherein the regulator is

looking at reducing the leverage in

response to the volatility in the markets

post the recent financial crisis and the

threats it posed to the real economy.

Though it is a calibrated measure to tame

risks to real economy and to achievefinancial stability, if not followed by

other markets where the participants can

easily shift such as to a currency trading

platform in the UK keeping at bay the

original intent of the regulators to reduce

volatility in the currency markets. Not


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only that US markets would lose the

price setting power to UK spot currency

market but also that the undue volatility

that the regulators wished to curb could

ever never have been achieved as the UK

spot currency markets increasedvolatility would spread the same to the

US markets. It emphasizes that among

regulatory trajectories across markets in

which similar products are being traded,

there needs to be close coordination in

regulation between the geographies and

among the cash, derivative and other type

of regulated exchanges.

With the US having a long history ofcommodity futures, US exchanges have

graduated to level where participants are

classified based on their commercial and

non-commercial interest. Subsequently,

the exchanges charge differential margins

to their members. For example,

speculators are asked to deposit highermargins than hedgers (see table 2).

Offering this incentive of a lower

transaction cost to hedgers helps the

exchanges attract the hedge interests on

to the exchange platform. On the other

hand, imposition of higher margins on

speculators helps keep tab on speculation.

Leverage provided to trade on exchanges

is lower in developing countries than that

of the developed countries.

Table 2:Margining (Initial margin/lot) and leverage in futures contracts across markets and asset classes

Nation Parameter Non-agri commodity Agri-commodity Currency Stock Index

US Margin

Speculator $5063;

hedger $3750

Speculator: $2700;

hedger $2000

Speculator - $4,050;

hedger - $ 3,000

Speculator: $28,125;

hedger :$22,500

Leverage

Speculator -1:14.8;

hedger 1:20

Speculator -1:18.5;

hedger - 1:25

Speculator - 1: 40.35;

hedger - 1:54.47

Speculator - 1:10;

hedger - 1:12.5

UKMargin

$3520.0 - $ 4000.0 per

lot NE NE 3,200

Leverage 1:21.3 - 1:18.7 NE NE 1:17.5

Japan

Margin

Clearing Margin - JPY

150,000 JPY 27,000 NE JPY 390,000Leverage 1:26.6 1:16 NE 1:24.6

S Korea

Margin NA NE

Member - 3%,

Customer - 4.5% NE

Leverage NA NE

Speculator -1:22.2;

hedger - 1:33.3 NE

China

Margin 8% 5% NE 12%

Leverage 1:12.5 1:20 NE 1:8.3

Brazil

Margin NE NE BRL 10,340 NE

Leverage NE NE 1:8.4 NE

India

Margin 5% 5% 1.75% 10%

Leverage 1:20 1:20 1:1.57.1 1:10

Note: The commodity underlings in the exchanges across the nations for non agri sector is crude oil traded at US (CME),UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soybean traded at US (CME), Japan (TGE),

China (DCE) and India (MCX); the currency underlings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF)

and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlings in the

exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100,

NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively. NE: Not Examined

Source: Exchanges websites


13/37

Low leverage in developing countries can

be due to the fact that in developing

markets, political and policy interests

exert more control on exchanges to keep

a check on prices compared to developed

countries. Developed countries provide

higher leverage to attract international

participation. Margins in the US, the UK,

Japan, etc are set on absolute terms on

individual contract basis, while

developing countries levy margins on the

percentage value of contracts. The

advantage of applying margins on the

percentage value of a contract size is that

the margin increases or decreases with arise or fall in the price of the contract

thereby keeping the leverage at the same

level. Thus, the relative increase in

margin along with either a rise or fall in

the price of the contract acts a deterrent

for speculators to push up or pull down

the prices, for their own profits.

Different asset classes compared, the

margin requirement for currencyderivatives is the lowest as the price

variation in currency derivatives is very

low. The leverage on currency futures is

on the higher side, in both developed and

developing countries, as currencies have

become global commodities and there

arise the need for widening of

participation and convergence of as much

information as possible. Trading in a

particular countrys currency takes placein many other countries across the world.

This means if in a given market trading is

suppressed by increasing margins, it will

lead to export of this domestic market

trade to overseas markets.

A Tale of US FX Markets High-

Leverage Cash Vs Low-Leverage

Derivatives

Forex cash markets in the US, which

recently came to be regulated by CFTC,have a higher leverage (despite the recent

intervention by the regulator) or in few

cases a similar leverage compared with

their derivative counterpart. It essentially

defies the logic that the market which is

supposed to transact the underlying (not

risks) should have a relatively lower

leverage compared with the market which

is expected to attract wider participation

to efficiently discover the future

exchange rate that could help converge as

much information as possible and also

help the participants transact risks in a

most cost-effective way. As both the

markets are supposed to clear daily,

preventing accumulation of financial

risks cannot remain the justification for

providing one market with a higher

leverage compared with the other market.A reduction in the leverage for the cash

FX markets and/or a gradual increase in

the leverage of the FX derivative markets

would help the markets effectively serve

the objectives for which they exist and

take better advantage of their

coexistence. However, it has the potential

to lead to same bargaining point for the

US spot forex industry that the US

commodity derivatives industry ralliedupon i.e. participation could spill over

into other geographies and that the US

markets would turn into being price

takers than be the price setters as they

are presently. Taking a step further if the

regulators for various markets and


14/37

geographies closely coordinate with each

other to close down the regulatory

arbitrages that might exist and learn from

each others regulatory experience, it

would help nations coexist with stable

economic and business conditions and

trade environment thereby supporting and

sustaining the ongoing process of

globalization than for them to quietly end

up in markets to manage their currencies

leading to the trade tussle as was the

situation during late 2010.

What is much visible in todays currency

markets regulation could occur in other

markets also as the derivative and spot

markets integrate leading up to global

economic integration. In addition, weak

and uncoordinated policy of margining as

it exists in the currency markets

worldwide (especially so in the spot

markets which have an immediate

influence on the rates) could also lead to

undue growth in markets keeping them

away from ability of the government forintervention even if they were to notice

collective irrationality in the market.

Exactly the same occurred in the

Japanese Yen (JPY) markets wherein the

JPY strengthened much in the last six

months as the corporates, exporters and

the governments could only watch it

helplessly except for one bout of

intervention by the Japanese government.

Companies/exporters and governmentcould only make statements in the press

about the unhealthy rise of JPY but not

do anything about it. Hence, only a

better coordination and cooperation

among the national regulators themselves

and those in various geographies and the

effective use of regulatory tools such as

this on controlling leverage by the

exchanges and regulators can only

prevent this. Can IOSCO or G-20 be the

forum wherein the national regulators

could synergistically work together? This

could perhaps be better discussed after

having an understanding of other

un/related regulatory tools that exist in

the in the world of markets for futures in

a range of asset classes.

Financial Insolvency Risks and Role of

Mark-to-Market Margins

While the risk of higher volatility is a riskfaced by the real economy wherein the

contagious nature of derivative market

price behaviour could spill over to spot

markets thereby transforming price risk

into risk premiums in the supply chain.

Trading in derivative markets also pose

risks to the market, with the risk of

financial insolvency arising out of undue

volatility in prices and the risk of not

being able to receive or provide

deliveries by hedgers who intend to do

the same.

As positions in a derivative market could

remain open for few seconds to few

months or few years depending on the

length of the contracts and the

participants need for risk management,

the price of the underlying at any point of

time would have changed drastically

from the price at the time of entry. It

requires that depending on entry and the

respective notional exit position (last

traded price of the same contract) at any

point of time (that the market player

would have to take to close down their


15/37

positions) should be monitored per the

prevailing market conditions to prevent

financial risks from accumulating in the

derivative markets. The risk of

accumulation of financial risks in this

market is being avoided by the

derivatives markets themselves or their

clearing houses through another type of

margin namely, mark-to-market margin

which is monitored on a real time basis

for deficits to be collected before it

exceeds the security deposits of the

member/traders held by the exchanges.

While the MTM margin concept exists

across exchanges and asset classes, its

use in a real situation varies across

exchanges and asset classes. The

effectiveness of its use on financial risk

management by the exchanges would

depend on whether there exists a daily

price band beyond which losses cannot

increase, the kind and the amount of

security deposits collected by the

exchanges, the extent of anticipatedvolatility in the prices of underlying

positions, etc. In addition, the recent

electronification of the markets has not

only provided for an opportunity of real-

time monitoring of notional profits/losses

by the participants but also enabled the

exchanges to pre-warn the traders of their

margin utilization against the notional

losses that have been accumulated till

that time on a netted market-wideposition basis. Such warnings as provided

by the exchanges make markets not only

participant-friendly but also risk-proofed.

MTM The need for organized

clearing of CDS markets

Discussions about the goodness of MTM

margining practices of exchange-traded

derivatives markets came to the fore

during the recent global financial crisis

caused by OTC derivatives such as CDS

(credit default swap) and CDO (credit

debt obligation). Being privately

negotiated contracts, these OTC

derivatives neither had a defined

margining system (security deposit) nor

were marked-to-market every day to be

cleared by an approved clearing house.

When the crisis emerged, the holders of

these instruments did not know exactly

the worth of the CDO/CDS assets beingcarried in their books and hence they

tended to accumulate losses beyond their

ability. Had these contracts been marked-

to-market and the financial risk cleared

on a periodical basis, as followed by

exchange traded derivatives markets, not

only that the risks would have been better

contained, but also advance signals of

this impending crisis, would have been

sent out for appropriate policy makingbefore bubbles could grow into

cataclysmic proportions. It would also

have made the market participants to

incorporate this risk into the pricing of

CDO/CDS that they were trading on. In

the absence of an effective MTM

margining system, there always existed a

largedefault risk (both financial and

delivery) warranting a chain reaction in

markets not necessarily due to their

interconnectedness but because of

participation of the same set of traders

across the board in most asset classes. In

short, MTM margining prevents

exchanges from financial defaults of its


16/37

participants and hence preventing its

cascading impact on the rest of financial

sector as it happened in the case of

Lehmanns collapse. Similarly, an

additional delivery period margin in case

of deliverable derivatives contracts helps

the derivative market cover the risk of

delivery failure (Smetters, 2010)10.

Markets will achieve an ideal state, in

terms of their own risk management, if

the asset classes are made ideal to be

traded on transparent electronic

exchange-traded markets and profits and

losses are tracked on a real-time basis

against the collateral held by the

participant in the clearing house; MTM

profit/losses are debited or collected on a

daily basis to prevent accumulation of

risks beyond a day and, thus, enable

participants to assess their risks based on

their fund availability, risk management

needs, risk bearing ability, and future

price or return expectations based on the

fundamentals of the asset classes than theanimal spirits. The price at which

markets settle on a daily basis varies

from market to market. Developed

countries such as the US and the UK and

many developing countries, including

India, follow SPAN margining system for

calculating MTM. Thus, overall,

exchanges have their own systems of

calculating their daily close based on

10Kent Smetters, professor of insurance & risk

mgmt at Wharton Regulating the Unknown: Can

Financial Reform Prevent Another Crisis?

http://www.knowledgeatwharton.com.cn/index.cf

m?fa=viewfeature&articleid=2245&l=1&&&lang

uageid=1

volatility in prices and market- wide risk

expectations. Unlike exchange-traded

standardized derivative contracts, over-

the-counter (OTC) derivatives are

customised bilateral contracts between

buyers and sellers, and are not traded on

exchanges. So, market prices of these

instruments are not established by any

active and a regulated market trading in

them. Market values in the case of OTC

derivatives are, therefore, not objectively

determined or readily available.

Therefore, they are difficult to be

marked-to-market.

2. Price Limits Tackling the

Herd Behaviour

Volatility in the price of the underlying is

an indicator of risks that could potentially

accumulate to be reflected in the spot

market over a period of time resulting in

gravity-defying prices of the asset class.

Particularly, if the volatility is the result

of a spill-over from the overlyingderivative markets, it would be of

concern to both policymakers and

regulators.

Yet another way in which derivative

markets have been used to contain the

financial risks is by fixing a price band,

called price circuit filters in markets

technical parlance or price limits in the

general global parlance. If in line with thehistorical cash market trends i.e. historic

price volatility seen in the cash markets,

it would remain a tool to prevent the

contagion that a loosely regulated

derivative market would otherwise create

in the underlying cash market. By virtue
http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1http://www.knowledgeatwharton.com.cn/index.cfm?fa=viewfeature&articleid=2245&l=1&&&languageid=1


17/37

of price limits, extreme price movements

associated with panic or excessive

speculation is restricted to the average

level the same information would have

created in a cash market and thus helping

in curbing undue one-way movement in

prices in a futures markets.

Flash Crash of 2010 and the

Importance of Price Limits

The recent infamous May 6 flash crash in

the US equity market is a case in point

that underscores the importance of price

limits. On May 6, Dow Jones Industrial

Averages sudden drop of nearly 1,000points that erased $862 billion from the

value of equities in less than 20 minutes

that rattled US investors confidence,

could obviously have been averted had

there been appropriate price limits in the

underlying stocks. Understandably now,

many exchanges that have earlier

dismantled this instrument of risk

management, are now reportedly

contemplating to introduce them. From

September 27, 2010, Brazils BM&F

Bovespa introduced price circuit breaker

that stops shares, ETFs, and other assets

traded on the spot market from deviating

more than 15 percent of the previous

days closing price.

Price limit is best fixed if it closely

resembles the price behaviour as it would

exist in the cash markets of the respective

underlying asset classes. A price limit so

fixed serves the dual purpose of

preventing trades from happening at

prices at a higher percentage movement

than that is allowed on an exchange

platform as the trade is stopped for some

time and provides an opportunity to

indicate to the market participants that

there is something fundamentally wrong

in their price discovery process thereby

providing them an opportunity to correct

themselves when the market opens. It

also prevents the herd behaviour that

exists among many who overlook the

fundamentals. The findings of Anthony

Hall and Paul Kofman (2001)11conclude

that price limits help control contract

default risk and, thus, reduce required

margins and, in turn, cost of transaction.

A lot of research has been conducted on

the impact and utility of price limits.

From all these studies which have

attempted to examine the impact of price

limits one can safely conclude that the

benefits derived from imposition of price

limits far outweigh the perceived

shortcomings of this tool. The existence

of price limits in certain futures markets

is explained by way of demonstrating that

price limits may act as a partial substitutefor margin requirements in ensuring

contract performance (Brennan, 1986)12.

The size of margin is negatively

correlated with the extent of price limits.

Empirical results cast doubt over the

notion that price limits be abolished

11Hall, Anthony D. and Kofman, Paul (2001).Regulatory Tools and Price Changes in Futures

Markets School of Finance and Economics

University of Technology, Sydney

12Brennan, M. (1986), A Theory of Price Limits

in Futures Markets, Journal of Financial

Economics, 16, 213-233


18/37

(Chen, 2002)13. Price limits enable

traders to better meet variation margin

calls by giving them time to raise funds,

and by making more predictable the

amount of cash they may need during any

given period of time. Ackert et al

(1994)14 were of the view that price

limits decrease the margin that brokers

and exchanges require since the amount

of risk they bear under a system of price

limits is smaller than the amount that

they would incur if prices were

completely unconstrained. Longin

(1999)15 Imposition of a bottoming price

level (to support producers) or a toppingprice level (to protect consumers) can

reduce market price volatility. However,

price limiters influence the price

dynamics in an intricate way and may

cause volatility clustering (Hea and

Westerhoff, 2005)16. The findings of

13Chen, Haiwei (2002) Price Limits and Margin

Requirements in Futures Markets The Financial

Review 37 (2002) 105--121

14Ackert, Lucy F.; Hunter, William C. and

Laurier, Wilfrid, Rational price limits in futures

markets: tests of a simple optimizing model.

Review of Financial Economics Volume 4, Issue

1, Autumn 1994, Pages 93-108.

15 Longin, Franqois M. Optimal Margin Level

in Futures Markets: Extreme Price Movements

The Journal of Futures Markets, Vol. 19, No, 2.

127-152(1999)

16Hea, Xue-Zhong and Westerhoff, Frank H.

Commodity markets, price limiters and

speculative price dynamics Journal of Economic

Dynamics & Control 29 (2005) 15771596

Evans and Mahoney (1996)17 on impact

of price limits on New York Cotton

Exchanges cotton options contract show

that when price limit is imposed, volume

in options contracts decreases compared

with the absence of price limits. At the

same time, aggregate volume in futures

and options contract remains the same

when price limit is imposed, which

indicates that market participants react

rationally to the price limit in the futures

market by transferring their trading

activity to a market without price limits

and that in a market without price limits,

participants prefer options thanfutures. Constraining prices reduce the

probability of contract repudiation

resulting from unfavourable price

movements and, thus, lowers risk.

Markets often witness large swing in

prices (possibly due to overreaction) and

price limit as a tool of risk management

helps cool down the market. It helps in

avoiding the formation of speculative

bubbles dampening the chances offinancial crises (Fernandes and Rocha,

2007)18.

17Evans Joan & Mahoney James M., 1996. "The

effects of daily price limits on cotton futures and

options trading," Research Paper 9627, Federal

Reserve Bank of New York.

18

Fernandes, Marcelo and Aurlio Dos SantosRocha, Marco, Are Price Limits on Futures

Markets that Cool? Evidence from the Brazilian

Mercantile and Futures Exchange (Spring 2007).

Journal of Financial Econometrics, Vol. 5, Issue

2, pp. 219-242, 2007. Available at SSRN:

http://ssrn.com/abstract=1145513 or

doi:10.1093/jjfinec/nbm001


19/37


20/37

relaxed price limit (with the UK having

absolutely no limits). Notably, the CME

(US) in agri futures and B&MF (Brazil)

in currency futures provide ample

opportunity for price discovery in the

final phase of the contract (spot month),

without enforcing any price limit. On the

other hand, emerging nations like India

and China have differential price limit

system for currency and agri futures

respectively depending on the maturity of

the contract month (see table 3). While

China follows western counterparts

practice of having relatively relaxed price

limits in the spot month, Indianexchanges regulation impose a tighter

price band in the near months.

Considering that there are always

possibilities of price manipulations in the

near-month contract and it would have

direct impact on the underlying markets,

the approach of much tightly regulating

price limits seems to be risk-averse while

allowing for information to converge into

the markets. An overarching aspect ofprice limits that are levied in markets

under comparison in the paper is that

while developed nations like the US and

Japan set price limits (commodities) in

absolute terms as like their margin

which are also set in absolute terms,

emerging nations follow a uniform policy

of percentage price limits across asset

classes. Also, with the market getting

more and more dynamic, it is essential

for regulators to dynamically alter price

limits. In this context, though regulators,

along with exchanges, in India, the US

and some other countries act dynamically

in response to changing market

conditions, daily price limits in Japan are

decided only at the meetings of

exchanges board of directors that are

conducted quarterly.

3. Position Limits

An efficient market is the one that has a

balanced and healthy mix of both

commercial and non-commercial

participants. While commercial

participants participate to hedge the price

risk that arises from their physical market

positions, non-commercial participants

trade purely for profits. For the latter,

volatility is the key as their profits comefrom volatility (anticipated price

movements). In quest of profits, non-

commercial participants have the

potential to escalate volatility by building

up large positions in the market

sometimes unilaterally and sometimes in

conjunction with other traders, thereby

jacking up prices far above what the

underlying fundamentals would justify.

Therefore, the unregulated building up of

price volatility in the derivatives market

poses a serious threat of price

manipulation, which affects efficiency of

the price discovery processone of the

two most critical functions of the

exchange-traded derivatives market. To

counter the risk of price manipulation

(possibly by way of building up large

positions in markets), a regulatory toolwidely used by exchanges and regulators

worldwide is known as position limits

i.e. limit on a participants position.

Imposition of position limits on

commodity futures curbs excessive

speculation and, thus, manipulation


21/37

(Ebrahim, 2010)19. Importantly,

acknowledging the differentiation in the

role of members, proprietors and clients,

generally position limits are variedly

imposed on the nature of participants.

Notably, position limit deters

concentration of positions and spreads

liquidity among heterogeneous

participants with diversified price views.

In this context, a financial market

incident of 1998 would make a relevant

read. A small group of experts gave the

market jitters as their company, Long-

Term Capital Management (LTCM),

collapsed, losing US$4.5 billion in just a

couple of months. What a probe into the

incident found as the primary reason

behind the fall of LTCM was irrational

over-exposure to an illiquid asset class -

Danish mortgage bonds. Over-exposure

was possible as there was no restriction

on product portfolio and too much of

borrowed money was used for high

market exposure, as there was norestriction on exposure. Inference: had

there been effective regulation, such as a

limit on maximum allowable position in a

particular asset class, on the functioning

of LTCM, the disaster could have been

converted into an unfortunate incident.

In a recent development, US President

Barrack Obama, on July 21, 2010, signed

19 Ebrahim, Muhammed Shahid, Do PositionLimits Curb Futures Market Manipulation? ASimple General Equilibrium Explanation

(August 30, 2010). Available at SSRN:http://ssrn.com/abstract=1668785

the Dodd-Frank Wall Street Reform

Act into a law to reform the regulatory

system in the country and to implement

restrictions. Accordingly, various

regulatory changes within the financial

services industry aim to impose position

limits in commodity derivatives across

both futures and OTC positions. But it is

obvious that in absence of such initiatives

throughout the world in unison, there are

serious and realistic apprehensions

that imposition of position limits in

isolation (in some given economies) will

drive the trade volume of more

stringently regulated markets tounregulated or less stringently regulated

markets. And, this will not only shift

price setting power of a market place by

shifting the volumes into the unregulated

market but also do not serve the intended

purpose.

Position limits help prevent market abuse

which is otherwise possible for a limited

number of large and powerfulparticipants. In the spot month, as a risk

management measure the limits are set

thinner to control chances of any price

manipulation, because when a futures

contract nears expiry its liquidity

declines. Genuine hedgers in all the

countries and exchanges analysed above

are given exemptions on submission of

adequate proofs of underlying

commodities exposure.

Exchanges in countries analysed, as in

table 4, impose position limits, in varying

degrees, except the Intercontinental

Exchange (ICE) in the UK.


22/37

Table 4: Position limits (lots) in futures contracts across markets and asset classes

Nation Non-agri commodity Agri-commodity Currency Stock Index

US Spot mth: 3000;Spot mth: 600; Single mth:6,500; All mths: 10,000; No limits Net 20,0001;

UK No limits2 NE NE -

Japan

Commercials &

investment trust: 12,800;Else: 2,400

Spot mth: 500; 2nd: 2,000;

3rd: 5,000; 4th: 10,000;5th onward 10,000 to 30,000 NE No information

S

Korea NE NE No limits3 NE

China

3rd mth: 15%, 10%, 5%proportion; 2nd mth:20000, 10000, 1000; 1stmth: 5000, 2000, 300; at

brokerage, proprietary,clients level respectively

Broker: 25%; Non-broker:20%; Customer: 10% ofmarket open position limit;

Near month 6,250; 5,000;2,500 respectively NE 10,0004

Brazil NE NEHigher of 10,000 or 20% ofOI NE

India

Client: 4,00,000 barrels;Member: higher of12,00,000 barrels or 15%of open positions

All mthsClient: 20,000MT; Member: higher of

60,000 MT or 15% of marketopen position; Near mthClient: 6,000 MT; members:higher of 18,000 MT or 15%

Clients - higher of 6% of OIor USD 10 million; trading

members - higher of 15%of OI or USD 50 million,

banks - higher of 15% of OIor USD 100 million

Member: higher

of Rs. 500 croresor 15% of totalOI;Client: 5% of OI

Note: The commodity underlyings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE),

Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India

(MCX); the currency underlyings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD,

USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US (CME), UK (NYSE LIFFE), Japan

(OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively; NE: Not

Examined

1: Net of all contracts combined (long or short); 2: Positions at ICE greater than 100 lots in all contract months to be reported on a daily

basis. Exchange can prevent the development of excessive position/unwarranted speculation where appropriate; 3: Can be adopted whenKRX deems necessary; 4: Long or short position for all contracts month combinedSource: Exchanges websites

However, at the ICE, if members hold

positions greater than 100 lots, they are

required to report to the exchange on a

daily basis. One is not sure what action

follows and there is no transparent policy

on what should be done in case of large

concentration of positions in a particular

contract by a particular participant. In

the absence of any transparent regulations

requiring examination of the data for

further regulatory action, one can

conveniently assume that the business

interests of the exchange would prevail.

In the above case, the ICE also reserves

the right to prevent the development of

excessive position/unwarranted

speculation where appropriate. The

Shanghai Futures Exchange (SHFE) in

China has imposed different position

limits up to third month of futures

contract. The SHFE also adopts the

system of large positions reporting

system. When the speculative positions

of a kind of futures contracts reached or

surpass 80% of the permissible

speculative positions limit, members or

clients are obliged to report the status of

capital and position holdings to the

Exchange and clients are required to

make such reports through Brokerage


23/37

members. The Exchange may stipulate or

adjust the reporting level according to the

risk status of the market. In US, position

limits are applicable only in the

expiration month, while the

accountability levels for the positions of

more than 20,000 lots have been applied

for all the months.

The UK seems to be quite liberal in terms

of enforcing position limits across

different asset classes. For example, a

Bloomberg news item released on

January 5, 2010 reads One Company

Holds at Least 40% of London March

Copper Shorts. Unless thereportedhuge

positions (i.e. 40%) are for bona fide

hedging purpose, the high concentration

definitely poses a risk to market

equilibrium.

4. Periodical Review of Contract

Specifications

It is essential that specifications of

futures contracts are designed keeping the

interests of all stakeholders in mind

that they appeal to all categories of

market participants and would enthuse

accumulation of a healthy mix of

participation interests from hedgers and

arbitragers. A slight tilt towards any of

these means the contract will not be able

to take off. Design and introduction of

futures contracts involve an expensiveand time-consuming process, especially

when it is a brand new contract with no

global precedence to refer to. Once a

contract is launched, modification of the

existing/running contracts is not allowed,

unless liquidity dries up altogether.

Hence, as in todays world where futures

contracts are made available for several

years, going for changes becomes a long-

drawn process. Moreover, as time

progresses and market dynamics changes,

the contract needs to evolve to keep it

relevant to the market. For example, in

March 2009, Brent crude oil futures

contract which historically trades at a

discount to WTI, as former being a

comparable inferior quality, traded at

premium to WTI as high as USD 10 a

barrel (a highly improbable behaviour).

The reason for the same was a local issue.

During that time storages were up to thebrim in Cushing a land locked place

the main delivery centre for WTI crude,

began to reflect the local fundamentals

compared with it being a global

benchmark. The participants who may

have hedged during this time period

looking at historical price behaviour

would have allocated wrong resources

which may create systemic risk for the

markets.

When exchanges fail to adapt to changing

market dynamics, the risk to the

efficiency of its price discovery process

arises. For example, waking up to non-

convergence of cotton spot and futures

prices, CME, of late, is contemplating

various proposals to delete a few existing

deliver centres where the relevant grade

cotton production has come down and toadd the ones where production and

physical trading have become more

active in recent years. Hence to keep the

contract specification relevant to the

market it needs to keep evolving with

changing market conditions and the


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exchanges and regulators would have to

consciously monitor the same analyse the

potential impacts of such changes on the

contract and hence the trading behaviour.

5. Robust Spot Price Polling,Dissemination and Final

Settlement

The derivatives market complements the

functioning of the spot market by

discovering future cash prices for the

participants of the spot market. In order

that the derivatives market performs this

role efficiently, futures prices would have

to efficiently reflect the underlying

fundamentals as it exists in the cash

markets besides accounting for

anticipated changes in the economic

conditions and fundamentals at a future

point in time. Ideally, the spot price of

the underlying commodity and the

futures price of the contract of the same

underlying commodity should converge

as the contract advances towards itsmaturity. Divergence between spot and

futures prices poses a threat to efficient

price discovery of futures trading and

also to its hedge efficiency.

Wide dissemination of polled spot prices

and market discovered futures prices

holds the key to countering the potential

risk of divergence between spot and

futures prices at it would help arbitragersto identify opportunities and to make the

cash and futures markets sync up

appropriately.

Importantly, for arbitrageurs to act in

markets, polling of spot prices needs to

be authentic i.e. without any bias or

inherent defects and should remain the

best reflector of the underlying spot

market fundamentals. Therefore, a robust

spot price polling mechanism is critical to

avoiding this divergence. Another

important facet of spot price polling is

that there should be regular check on the

relevance of the pre-decided underlying

spot market for the overlying derivatives

contract and any changes in the same

should be reflected in contract

specifications as well. Importantly for the

final settlement of derivatives contract,

the correct spot prices are vital if thecontract is cash settled. In case cash

settlement of a futures contract on expiry

is based on faulty spot prices or other

imperfect ingredients such as faulty

storage cost and ill-representation of

moisture content in the underlying

commodities (largely agri-commodities)

which have the potential to distort the

spot prices would have to be avoided.

Interestingly, in mid-June 2010, the

difference between cash wheat prices in

Kansas and July 2010 Kansas City Board

of Trade wheat futures diverged sharply

instead of converging as cash and futures

prices are normally expected to. One of

the many reasons cited for this non-

convergence was fading relevance of the

underlying wheat quality (due to falling

production). Therefore, acknowledgingthe importance of convergence, the

exchange decided (on a pilot basis) to

close the gap between futures and spot

prices by adjusting it to varying storage

cost.


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Penalty as a tool to Discouraging

Delivery Default

Delivery default penalty is a punitive toolimposed to discourage derivatives marketparticipants from defaulting againstfutures contract obligations. A longhedger may have committed an exportcontract with his overseas buyer andwould have planned to fulfil hisobligation by taking the delivery againsthis futures position. If the seller on theday of expiry of the futures contract failsto deliver, the long hedger bears the bruntof this failure.

Therefore, as a measure of precaution inphysically settled contracts, exchangesincrease the margins for contractsapproaching their maturity. Still, ifcounterparty defaults, exchanges have aprovision to penalise the defaulter notonly to discourage potential futuredelivery defaults (a risk to the price riskmanagement function of derivativestrade) but also to make good for theaffected partys loss. The penalty varies

from exchange to exchange, from acertain percentage of contract value to thedefaulter bearing the difference in thefinal settlement and the procurement costof equivalent quantity and quality.

All countries analysed, as in table 5, havedifferent methods of arriving at thesettlement price on expiry of a futurescontract. For oil futures contracts, the USand China follow compulsory delivery

mechanism for settlement; the UK andJapan adopt cash settlement procedure.Exchanges in the UK allow EFP as amode of physical delivery. In India, crudeoil futures contracts have provided forboth options i.e. physical delivery ispossible when the intention of bothbuyers and sellers are matched. In all

exchanges which provide for physicaldelivery, defaults are dealt with byimposition of penalty (at leastcompensating for the losses).

In the US, the defaulting party is slappedwith a penalty of 20% of the contractvalue. India too imposes a penalty of2.5% and replacement cost of 4% of thesettlement price. The final settlement ofcrude oil futures on CME is done by amethod called as volume weightedaverage price (VWAP). On expiry offutures contracts, the trades occurringbetween 14:28:00 and 14:30:00 EasternTime is considered for declaring the final

rates. In this method, the volumes areweighted against the prices to arrive atthe final settlement price.

As far as agri-commodities are

concerned, all exchanges have the

provision of compulsory delivery. On

CME, soybean futures contract is settled

at the price at which the Pit Committee,

in consultation with the exchange staff,

determines the preponderance of the

volume in the closing range. In India, the

settlement procedure of soybean futures

is simple and straight forward. The

exchange takes simple average of last 3

days spot prices of soybean to arrive at

the due date rate following the expiry of

the futures contract.

Coming to currency futures contracts, the

US and Japan enforce settlement through

physical delivery, as they have no issues

with full convertibility. Currency

derivatives in India and Brazil, which

have not yet allowed full convertibility of

their currencies, are settled against cash.


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Table 5: Settlement, due date rate (DDR) and delivery default penalty (DDP) in futures contracts across markets and asset clas

Non-agri commodity Agri commodity Currency Stock Index

US Settlement Physical Physical Physical Cash

DDR

VWAP between 14:28:00-

14:30:00 Eastern Time1

Pit Committee price, in

consultation with Exchange2 ECSP3 SOQ4

DDP 20% of contract value

Not more than delivery price

& reasonable market price - None

UK Settlement

Cashdelivery through

EFP NE NE Cash

DDR

ICE Brent Index price on

next day of expiry5 NE NE EDSP6

DDP None NE NE None

Japan Settlement Cash settled Physical NE Cash

DDR Price published by Platts7

Final contract price of

settlement period NE SQ8

DDP None1% Charges, max Yen 100

million/suspend trading NE None

S Korea Settlement NE NE Physical delivery NE

DDR NE NEClosing execution price oflast trading day NE

DDP NE NE

Compensate loss &

expenses incurred NE

China Settlement Physical delivery Physical NE Cash

DDR - - NE

Arithmetic avg. of

underlying index in last

hrs of last trading day

DDP - 5-20% of contract values NE None

Brazil Settlement NE NE Cash (in Brazilian Real) NE

DDR NE NE

Rate announced by Central

Bank of Brazil NE

DDP NE NE None NEIndia Settlement Both Option Physical Cash (in Indian Rupees) Cash

DDR

Spot price of last trading

day (Ex Mumbai)

Simple average of last 3 days

spot prices

RBI reference rate of last

trading day

Closing value of spot ind

on last trading day

DDP

Penalty of 2.5% of DDR &

replacement cost of 4% of

DDR

3% of DDR + diff b/w DDR

& avg. of 3 highest spot

prices of next 5 days post

expiry None None

Note: The commodity underlyings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and

India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlyings in the exchanges in US (CME), So

Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US

(CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIF TY respectively;

NE: Not Examined;None - No (physical) delivery default penalty since no physical delivery settlement;

1: Front month in NYMEX WTI Crude Oil futures is settled at the VWAP (volume weighted average price) of trades occurring on expiry date b/w 14:28:00-14:30:00 ET; Settled at price at which Pit Committee, in consultation with Exchange staff determines traded the preponderance of vol in the closing range; 3: ECSP Expiring contract

settlement price is derived from more actively traded, next deferred contract month by applying appropriate spread differential b/w 1st& 2ndexpiring contracts to VWAP

sales between 9:15:30 to 9:15:59 a.m. CT; 4: Special Opening Quotation (SOQ)S&P 500 futures index is settled taking cash market prices of underlying stocks openin

prices the following day of expiry; 5: Index represents the average price of trading in the 21 day BFOE market in relevant delivery month as reported & confirmed by med

(industry); 6: Exchange Delivery Settlement Price (EDSP): final settlement price of the index is arrived by the outcome of the intra-day auction at the London Stock Exch

carried out on the last trading day; 7: Yen-based monthly avg. value of Dubai & Oman calculated by Exchange based on the prices reported by a price information vendor

(Platts); 8: Special Quotation or SQ calculation is based on the total opening prices of each component stock of Nikkei 225 on the business day following the last trading d

Source: Exchanges websites


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On CME in the US, EUROUSD currency

futures are settled based on a technique

similar to that of crude oil futures

(VWAP). The exchange for settlement of

EUROUSD contract provides a time

window of 30 seconds between 13:59:30and 14:00:00 CT. The trades in this

period are volume weighted and the final

settlement price is arrived at.

Stock indices futures on the exchanges

analysed, as in table 5, have largely

emerged as being cash settled as

exercising delivery for these contracts

constituting 50 to 500 shares is a tall

order task for the agency responsible forclearing the trade. Settlement of indices

varies from country to country. The CME

adopts a method called Special Opening

Quotation (SOQ) for arriving at the final

settlement price of S&P 500 futures

contract. SOQs are calculated based on

normal index calculation procedure

except that the values of the respective

components are taken as the actual

opening values for each of the component

equities. However, not all stocks will

actually record a transaction on the

opening bell of the New York Stock

Exchange (NYSE) or NASDAQ. Some

may open a few seconds, minutes or even

hours later. Thus, there will be

differences between the initial index

quotes on the Final Settlement Date

relative to the SOQ.

In the UK, the final settlement price of

FTSE 100 index futures contract is

arrived by a method known as Exchange

Delivery Settlement Price (EDSP). The

value of the FTSE 100 Index is

calculated by FTSE International with

reference to the outcome of the EDSP

intra-day auction at the London Stock

Exchange carried out on the last trading

day. EDSP for FTSE 100 futures contract

is based on the Index value created by the

intra-day auction in each of theconstituent securities which is run

specifically for that purpose by the

London Stock Exchange. For the duration

of the EDSP intra-day auction,

continuous electronic trading is

suspended in the respective securities.

NYSE Liffe declares the final settlement

price (the EDSP) against which all

outstanding open positions in that

delivery/expiry month are settled.

In Japan the final settlement price is

arrived at by a methodology known as

Special Quotation Calculation. It is based

on the total opening prices of each

component stock of Nikkei 225 on the

business day following the last trading

day.

The methodology adopted in India is thesimplest of all. The closing price of the

relevant underlying index in the capital

market segment (or cash market) of the

exchange on the last trading day of the

futures contract is taken for arriving at

the final settlement price. The closing

price of the underlying index constitutes

the closing prices of various stock

components that are calculated on the

basis of the last half an hour weighted

average price.

The methodologies adopted by the UK

and India are similar. In the UK,

settlement is arrived on next days cash

market auction prices, while in India


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settlement is arrived on the basis of the

cash markets last half hours weighted

average closing price. In todays fast-

paced and ever-changing financial market

scenario, there is always a possibility of

risk getting accumulated overnight.Under such conditions, India that settles

its stock index futures on the same day,

scores over the UK.

6. Net worth/Disclosure To

Attain and Retain Membership

Trading of derivatives is based on a high

degree of leverage. Therefore, it is

desirable that members participating inthe derivatives market have the requisite

eligibility including their net worth i.e.

they are capable of meeting all the

necessary parameters. In the event of

ineligible members transacting in the

derivatives market, the risk of default

looms large and may easily take the

shape of systemic risk in the market

ecosystem. To counter this systemic risk,

a tool that exchanges worldwide employ

is laying down strict guidelines in respect

of individuals net worth to determine

who is eligible for exchange membership.

Different types of exchange memberships

warrant different net

Regulatory Tools – Key to Market Efficiency

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