Policy issues

Policy issues

Q15.1: Are many developing countries developing derivatives
exchanges?
A: There are many attempts at starting derivatives exchanges. As with spot exchanges,
there have been relatively few successes in terms of obtaining highly liquid markets. See
Tsetsekos & Varangis (1997) and van der Bijl (1996). ••

Q15.2: Does derivatives trading throw up new threats to the
financial system?
A: Derivatives trading does bring a whole new class of leveraged positions in the economy.
From a systemic risk standpoint, however, there are no externalities or contagion
when we consider exchange–traded derivatives with novation at the clearing corporation.
In fact, to the extent that equity derivatives make it easier for policy makers to eliminate
leverage on India’s equity spot market, it will help reduce the vulnerability of India’s
equity market.
It is with OTC derivatives that there are more serious policy concerns, about the extent
to which a few large failures can destabilise the financial system. This is because OTC
derivatives innately involve credit risk, and there is a clear channel for contagion – where
the failure of one firm impacts upon its counterparties. ••
Also see: Steinherr (1998).

Q15.3: What about market manipulation on derivatives markets?
A: Futures or options based on physical delivery (as opposed to cash settlement) are vulnerable
to “short squeezes” and other manipulative schemes. For example, there was a
famous effort to corner the world market for silver, partly using the silver futures market
(Houthakker & Williamson 1996b). These dangers require a strong supervisory mecha-
nism to deal with market manipulation. •• Q15.4: What is the direction for policy in regard of the equity
derivatives and spot markets?
A: We can expect the equity spot market to move towards rolling settlement (i.e. to
become closer to a spot market). We can expect a regulatory prohibition of badla, as part
of the migration into a genuine spot market. In the area of exchange–traded derivatives,
index options are the logical next stepping stone for India’s markets. •• Also see: Shah & Thomas
(1999a).

Q15.5: What is the progress in terms of exchange–traded currency
and interest–rate derivatives?
A: None. ••

Q15.6: Are derivatives on Indian assets traded outside India?
A: In Hong Kong and Singapore, there are cash–settled forwards on the dollar–rupee
exchange rate, called “non–deliverable forwards”.
The Singapore Monetary Exchange (SIMEX) has chosen Nifty in order to trade products
based on an Indian index. This is a significant development, considering the success
at SIMEX in competing against the home–country index futures market in Japan and Taiwan.
••

Q15.7: What is the implication of Nifty futures and options
trading at SIMEX for India?
A: From an Indian perspective, it helps FDI and FII inflows into India, since investors
would have an additional avenue through which “India risk” can be hedged. Trades on
SIMEX would be convenient and hassle–free for the international investor, when compared
with the operational frictions involved in doing trades in India.
From an NSE perspective, SIMEX represents competition. If SIMEX offers a superior
market design, more efficient transacting, and a less onerous regulatory structure, it will
take order flow away from NSE.
SIMEX will also impose stress upon India’s regulatory apparatus. For example,
SIMEX will trade Nifty futures and options from the outset, while India’s regulators have
not yet permitted options trading. Similarly, if India’s regulators are confused on questions
such as margin setting, then many users will have the choice of walking away from
NSE to SIMEX. ••

Q15.8: How will the two markets interact?
A: There be arbitrage opportunities between the two markets. A large buy order going
to SIMEX will push up the price of Nifty futures at SIMEX. Then arbitrageurs will step
in, selling Nifty futures at SIMEX and buying Nifty futures at NSE. This could, in turn,
propagate back to the NSE cash market through normal spot–futures arbitrage in India.
Arbitrage involving options at SIMEX be done in two ways. An arbitrageur could
choose to do trades between Nifty options (SIMEX) and Nifty futures (SIMEX). Alternatively,
if Nifty futures are much more liquid, then the arbitrageur could choose to do
trades between Nifty options (SIMEX) directly to Nifty futures (NSE). •• Also see: Stoll & Whaley (1990).

Q15.9: Is SIMEX a serious threat to NSE?
A: If we consider the pure merits of the market, then the great mass of retail traders in
India is likely to generate liquidity at NSE in a way that SIMEX cannot access. The
international experience is that in countries which have a strong tradition of retail trading
on financial markets, offshore trading does not present a major threat to the local market,
which dominates price discovery. NSE is dominated by retail trading, and has had peak
stock market trading of $2 billion, which is enormous by world standards.
The major question mark is about margins and regulation. It took NSE five years to
get permissions to do index futures trading. The delay in obtaining permissions for index
options has yet to be seen; SIMEX will have a head start on Nifty options. The regulatory
posture in India could turn off users, and drive them off to Singapore. This is not just
an idle possibility; it was the case with the Japanese Nikkei 225 futures, where stifling
regulation in Japan led to a flowering of futures liquidity in Singapore.
In summary, as with the Nikkei 225, the success of SIMEX will depend upon a combination
of Indian retail dynamism, and the ability of regulators in India to comprehend
derivatives and come up with a fair regulatory structure. ••