Derivatives trading: OTC or on exchange?

WORLD MONEY

Just as the over-the-counter (OTC) interest rate and foreign exchange derivatives market in India has taken off, there is a new cloud on the horizon.

This is the Securities Laws (Amendment) Bill, 2003, now before Parliament. The principal object of the bill is to facilitate "structural transformation of stock exchanges from mutual organisational form to demutualised form".

The threat to the existence of the OTC market in interest rate and foreign exchange derivatives comes from the change in the definition of derivatives proposed in the bill. Before considering the issues arising, it is perhaps worth discussing some of the salient differences between OTC trading and exchange trading of financial instruments.

Exchange trading of financial instruments certainly has some advantages over the OTC market:

• Price transparency: At a given time, there will be a single price for a financial instrument traded on an exchange, which is available to all market participants.

In contrast, in OTC markets there can be different prices for different participants at the same point of time. For example, at 11 a m today, the price at which, say, Reliance will be able to buy spot dollars, is likely to be different from the price for ABC Company in Jalapaigudi.

Counterparty risk: All derivative instruments entail counterparty credit exposures. If one of the two parties to a contract fails before its maturity, the other party could face a major loss depending on how prices have moved in the interim.

Exchange trading eliminates counterparty exposure and risk through the process of initial margin, mark-to-market of the outstanding position on a daily basis, and adjustment of the margin in alignment with market prices. The effectiveness of the margin systems has been tested on various occasions.

To quote one, Barings Bank collapsed with losses of a billion dollars in trading the Nikkei index futures contract on SIMEX, the Singapore exchange. Nevertheless, all contracts were honoured, and no counterparty suffered any loss.

While these are significant positive features of exchange trading, they come at a cost "" cost not in terms of rupees, but in terms of flexibility. The reason is that exchange trading requires standardisation of the contract, typically in terms of, say, the amount of the contract and its maturity.

To illustrate, you could buy forward, say, $ 1,323,208 for any delivery date you may desire, in the OTC market. If forward delivery dollars are to be traded on an exchange in the form of a futures contract, its amount will have to be standardised (say, $ 25,000 per contract), and so would the maturity "" for instance, the second Wednesday of the maturity month. Standardisation is essential for exchange trading.

Standardisation also has a major implication for the end-user of derivatives for hedging price risks. He will rarely get an exactly matching hedge in traded derivatives: in general, the maturity and amount of his exposure will not match the traded instrument's.

Therefore, limiting derivatives to exchange traded ones would be a disservice to the hedger who often needs customised instruments. Exchange traded instruments are more useful for the trader/speculator, not so for the hedger because of the limitations flowing from standardisation.

Coming back to the Bill, the threat to the OTC market comes from the amendment to the definition of "derivative" proposed therein. The earlier definition, broadly speaking, limited the scope of the word to instruments derived from securities.

Therefore, it would seem that the requirement that "contracts in derivative (sic) shall be legal and valid (only) if such contracts are traded on a recognised stock exchange" was not applicable to, say, contracts in foreign exchange derivatives.

The amendment to the definition of derivatives now proposed expands the scope to include "swap (sic), options and hybrid instruments and other contracts for differences therefore". This would require that such derivatives in foreign exchange will also need to be traded on the floor of an exchange: even the forward contract, if cancelled, becomes a "contract for differences".

Another side-effect of the bill is also somewhat pernicious. Given its focus on exchange trading, it seems to give a lot more powers to the Securities and Exchange Board of India (Sebi) than the other regulator, namely the Reserve Bank of India (RBI).

For example, under Section 2(k), Sebi, and not the RBI, has been given wide powers to define swaps. Again, for spot transactions, the RBI's powers are limited to transactions in government securities. Surely, the RBI is the right regulator at least for all interest rate and currency transactions, spot or swaps?

One does not know whether the drafters have considered the exchange control requirements for foreign exchange derivatives, or have taken into account the practical impossibility of standardising swaps or other derivatives in both the foreign exchange and money markets!

Will it be practical to trade even plain vanilla swaps, let alone structured instruments, on an exchange? Even internationally, where derivatives exchanges have been operating for a much longer time, interest and currency swaps have remained a predominantly OTC instrument.

Currency options are traded both OTC and on exchanges, but the volumes in the former market are much higher. As the June 2003 BIS Quarterly Review of international banking and financial market developments acknowledges, "The most recent numbers also show that OTC business (in derivatives) expanded once again relative to that on exchanges".

If the Bill is passed in the present form, it has the potential to kill the derivatives market in interest rates and currencies, clearly a disservice to the end-users.

Email: avrco@vsnl.com