Ifs(Derivatives)(4)

8/12/2019 Ifs(Derivatives)(4)

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India's Financial System

Abstract

With recent growth rates among large countries second only to Chinas, India has

experienced nothing short of an economic transformation since the liberalization

process

began in the early 1990s In the last few years, with a soaring stoc! mar!et,

significant

foreign portfolio inflows including the largest pri"ate e#uity inflows in $sia, and a

rapidly de"eloping deri"ati"es mar!et, the Indian financial system has been

witnessing an

exciting era of transformation %he ban!ing sector has seen ma&or changes with

deregulation of interest rates and the emergence of strong domestic pri"ate players

as

well as foreign ban!s $t the same time, there is some e"idence of credit

constraints for

Indias '() firms that rely hea"ily on trade credit Corporate go"ernance norms in

India

ha"e strengthened rapidly in the past few years *amily businesses, howe"er, still

dominate the landscape and in"estor protection, while excellent on paper, appears

to be


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less effecti"e owing to an o"erburdened legal system and corruption In the last

few years

microfinance has contributed in a big way to financial inclusion and is now

attracting

"enture capital and for+profit companies both domestic and foreign

India's Financial System

Overview

-ne of the ma&or economic de"elopments of this decade has been the recent ta!e+


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off of India, with growth rates a"eraging in excess of ./ for the last four years, a

stoc!

mar!et that has risen o"er three+fold in as many years with a rising inflow of

foreign

in"estment In 00, total e#uity issuance reached 219bn in India, up per cent

(erger and ac#uisition "olume was a record 23.bn, up 4. per cent, dri"en by a

431 per

cent increase in outbound ac#uisitions exceeding for the first time inbound deal

"olumes

5ebt issuance reached an all+time high of 2143bn, up . per cent from a year

earlier

Indian companies were also among the world6s most acti"e issuers of depositary

receipts

in the first half of 00, accounting for one in three new issues globally, according

to the

7an! of 8ew or!

%he #uestions and challenges that India faces in the first decade of the new

millennium are therefore fundamentally different from those that it has wrestled

with for

decades after independence :iberalization and globalization ha"e breathed new

life into


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the foreign exchange mar!ets while simultaneously besetting them with new

challenges

Commodity trading, particularly trade in commodity futures, ha"e practically

started

from scratch to attain scale and attention %he ban!ing industry has mo"ed from an

era of

rigid controls and go"ernment interference to a more mar!et+go"erned system

8ew

pri"ate ban!s ha"e made their presence felt in a "ery strong way and se"eral

foreign

ban!s ha"e entered the country -"er the years, microfinance has emerged as an

important element of the Indian financial system increasing its outreach and

pro"iding

much+needed financial ser"ices to millions of poor Indian households

Financial System;


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%he word ;system;, in the term ;financial system;, implies a set of complex and

closely connected or interlined institutions, agents, practices, mar!ets, transactions,

claims, and liabilities in the economy %he financial system is concerned about

money, credit and finance+the three terms are intimately related yet are somewhat

different from each other Indian financial system consists of financial mar!et,

financial instruments and financial intermediation

Role/ Functions of Financial System:

$ financial system performs the following functionsate $greements being fre#uently used in inter+ban! transactions as

well as

for hedging of corporate ris!s 'imilarly currency swaps, forward contracts and

currency

options are being increasingly used by Indian companies to hedge currency ris!

11

*inally the mar!et for corporate control has seen a surge of acti"ity in India in

recent years *igures 11 shows the e"olution of mergers and ac#uisitions

in"ol"ing

Indian firms while table 13 lists the industries with maximum action *oreign

pri"ate

e#uity has been a ma&or player in this area with inflows of o"er 2 billion in

00, the

largest in any $sian country

%he next section ma!es an assessment of the legal and institutional aspects of


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in"estor protection in India 'ection 4 pro"ides the details of performance of

capital

mar!ets in India 'ection A pro"ides the trends of *II flows in India 'ection G

loo!s at

the performance aggregates of the ban!ing sector 'ection pro"ides corporate

go"ernance issues and recent findings %he last section highlights future research

issues

Stoc! $*c#an,es in India

India currently has two ma&or stoc! exchanges< the 8ational 'toc! )xchange

8')D established in 199A and the 7ombay 'toc! )xchange 7')D, the oldest

stoc!

exchange in $sia, established in 1.3G Kp to 199, 7') was a monopoly, mar!ed

with

inefficiencies, high costs of intermediation, and manipulati"e practices, so that

external

mar!et users often found themsel"es disad"antaged %he economics reforms

created four

new institutions< the 'ecurities and )xchanges 7oard of India ')7ID, the 8ational

'toc!


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)xchange 8')D, the 8ational 'ecurities Clearing Corporation 8'CCD, and the

8ational

'ecurities 5epository 8'5:D %he 8ational 'toc! )xchange 8')D, a limited

liability 1.

company owned by public sector financial institutions, now accounts for about

two+thirds

of the stoc! exchange trading in India, and "irtually all of its deri"ati"es trading

%he 8ational 'ecurities Clearing Corporation 8'CCD is the legal counter+party to

net obligations of each bro!erage firm, and thereby eliminates counter+party ris!

and

possibility of payments crises It follows a rigorous Pris! containment framewor!

in"ol"ing collateral and intraday monitoring %he 8'CC, duly assisted by the

8ational

'ecurities 5epository 8'5:D, has an excellent record of reliable settlement

schedules

since its inception in the mid+nineties

%he 'ecurities and )xchanges 7oard of India ')7ID has introduced a rigorous

regulatory regime to ensure fairness, transparency and good practice *or example,

for

greater transparency, ')7I has mandated mandatory disclosure for all transactions

where


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total #uantity of shares is more than 0G/ of the e#uity of the company 7ro!ers

disclose

to the stoc! exchange, immediately after trade execution, the name of the client in

addition to trade detailsB and the 'toc! exchange disseminates the information to

the

general public on the same day

%he new en"ironment of transparency, fairness and efficient regulation led 7'),

in 199, to also become a transparent electronic limit order boo! mar!et with anefficient

trading system similar to the 8') )#uity and e#uity deri"ati"es trading in India

has s!y+

roc!eted to record le"els o"er the course of the last ten years

In 00G, about G000 companies were listed and traded on 8') and?or 7') While

the dollar "alue of trading on the Indian stoc! exchanges is much lower than the

dollar

"alue of trading in )urope or in the K', it is important to note that the number of

e#uity

trades on 7')?8') is ten times greater than that of )uronext or :ondon, and of the

same

order of magnitude as that of 8$'5$Q?8') 'imilarly, the number of

deri"ati"es


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trades on 8') is se"eral times greater than that of )uronext? :ondon, and of an

order of

magnitude comparable to K' deri"ati"es exchanges %he number of trades is an

important indicator of the extent of in"estor interest and in"estor participation in

e#uities

and e#uity trading, and emphasizes the crucial importance of corporate go"ernance

practices in India

Institutional Features

%he transactions in secondary mar!ets li!e 8') and 7') go through clearing at

clearing corporations 8ational 'ecurities Clearing Corporation :imited 8'CC:D

for

8') trades, for instanceD where determination of funds and securities obligations

of the

trading members and settlement of the latter ta!e place $ll the securities are being

traded

and settled under %R rolling settlement H5ematerializedJ, trading of securities,

ie

paper+less trading using electronic accounts, now accounts for "irtually all e#uity

transactions %his was introduced to reduce the menace of fa!e and stolen

securities and A

to enhance the settlement efficiency, with the first depository 8ational 'ecurity


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5epository :imited established for 8') in 199 %his ushered the era of

paperless

trading and settlement %able 49 shows the progress of dematerialization at 8'5:

and

the Central 5epository 'er"ices IndiaD :imited C5':D %able 410 pro"ides the

deli"ery pattern of "arious stoc! exchanges in India $s a measure of in"estor

protection,

exchanges in India both the 8') and 7')D administer price bands and also

maintain strict

sur"eillance o"er mar!et acti"ities in illi#uid and "olatile stoc!s 7esides, 8'CC:

has put in place

an on+line monitoring and sur"eillance system and monitors members on a real

time basis In

addition, there is regulatory re#uirement by ')7I that 0/ of the acti"e trading

members being

inspected e"ery year to "erify their le"el of compliance with "arious rules

)ebt ar!et

%he debt mar!et in India has remained predominantly a wholesale mar!et 5uring

00G+00, the go"ernment and corporate sector collecti"ely has mobilized >s

trillion

from the primary debt mar!et -f which, 9/ were raised by go"ernment and

the


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commercial papers and bonds In recent years, there has been an increase in

issuance of G

corporate bonds with embedded put and call options %he ma&or part of debt is

pri"ately

placed with tenors of 1+1 years

@o"ernment securities include *ixed Coupon 7onds, *loating >ate 7onds, Sero

Coupon 7onds, and %+7ills %he secondary mar!et trades are negotiated between

participants with '@: 'ubsidiary @eneral :edgerD accounts with >7I %he8egotiated

5eli"ery 'ystem 85'D of >7I pro"ides electronic platform for negotiating trades

%rades are also executed on electronic platform of the Wholesale 5ebt (ar!et

W5(D

segment of 8') %able 41 shows the growth of W5( segment of 8') %he

a"erage

trade size in this mar!et has ho"ered around >s 30 million 2 13G millionD and

while

turno"er has risen significantly, the rise has not been uniform

Central and 'tate go"ernments together ha"e borrowed >s 1. trillion 2 AG

billionD grossD and repaid o"er >s .0 billion 2 13 billionD during 00G+0 -ut of

this

o"er >s 14 trillion 2 4G billionD was raised by central go"ernment through dated


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securities -n a net basis, the go"ernment has borrowed o"er >s 9G4 billion 2

4.4

billionD through dated securities and only slightly o"er >s . billion 2 03 billionD

through 4A+day %+7ills %he net borrowings of 'tate go"ernments in 00G+0

amounted

to slightly o"er >s 1GA billion 2 4.G billionD

%he yield on primary issues of dated go"ernment securities during 00G+0 "aried

between 9 / and 39. / against the range of AA9/ to .A / during 00A+0G%he

weighted a"erage yield on go"ernment dated securities increased to 34A/ from

11/ in

00A+0G

$t about / of the @5E, the corporate bond mar!et in India is small, marginal,

and heterogeneous in comparison with corporate bond mar!et in de"eloped

countries

While a corporate debt mar!et in India has existed in India since 19G0s, the bul! of

the

debt has been raised through pri"ate placements In 00A+0G, close to >s G94

billion

2 1A4 billionD was raised by the corporate sector through debt instruments, of

which


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pri"ate placements accounted for around 94 / In 00G+0, the entire amount of

o"er >s

39A billion 2 19.G billionD was raised by 99 issuers through 4 pri"ately placed

issues,

with no public issues at all *igure 44 shows the growth of pri"ate placement debt

in

India *inancial Institutions and ban!s dominate in pri"ate placements, issuing 3G

/ of

the total pri"ate placement of debt >efer *igure 4AD $round .1 / of the

resources

mobilized by pri"ate placement were distributed to *inancial and 7an!ing sector

and

9A / to Eower sector, while distribution to %elecommunications and Water

resources

together was less than 1 / 5uring 00G+0, the maturity profile of issues in

pri"ate

placements ranged between 1 months to A0 months

%o promote the corporate debt mar!et, especially secondary mar!et regulators

ha"e ta!en se"eral steps Corporate 5ebt instruments are traded both on 7') and

on

capital mar!et and the W5( segments of the 8') ')7I has already mandated

that all


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bonds traded on the 7') and 8') be executed on the basis of price?order

matching 'o,

the difference between trading of go"ernment securities and corporate debt mar!et

securities is that the latter are traded on the electronic limit order boo! li!e

e#uities 'ince

Fune 00, the C5': and 8'5: ha"e admitted debt instruments such as

debentures,

bonds, CEs C5s, etc $lso, ban!s, financial institutions and primary dealers ha"e

been

as!ed to hold bonds and debentures, pri"ately placed or other wise, in electronic

form $s

on (arch 00, o"er >s 44 trillion 2 .G billionD worth of bonds?debentures

were

a"ailable in paperless electronicD form consisting of G issuers with 13,G0.

debentures?bonds and 439 issuers with 3,4G3 issues of commercial paper

In terms of mar!et participants, apart from in"estors and bro!ers, there were 13

Erimary 5ealers . at the end of (arch 00 5uring 00G+0, ban!s Indian and

*oreignD

accounted for A/ of the W5( turno"er, while primary dealers accounted for

1/ of

the total turno"er >efer *igure 4GD In recent years mutual funds ha"e emerged as

an


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important in"estor class in the debt mar!et %hey also raise funds through the debt

mar!et (ost mutual funds ha"e specialized debt funds such as gilt funds and

li#uid

funds *oreign Institutional In"estors *IIsD are also permitted to in"est in treasury

and

corporate bonds, but up to a limit Ero"ident and pension funds are large in"estors

in debt

mar!et, predominantly in treasury and E'K bonds %hey are, howe"er, not "ery

acti"e

traders owing largely to regulatory restrictions

Conclusion:%he Indian financial system has undergone structural transformation

o"er the past decade %he financial sector has ac#uired strength, efficiency and

stability by the combined effect of competition, regulatory measures, and policy

en"ironment While competition, consolidation and con"ergence ha"e beenrecognized as the !ey dri"ers of the ban!ing sector in the coming years

)erivatives ar!et

A&S"RAC"

%he Indian deri"ati"e mar!et has become multi+trillion dollar mar!ets o"er the

years (ar!ed with the ability to partially and fully transfer the ris! by loc!ing inassets prices, deri"ati"es are gaining popularity among the in"estors 'ince the

economic reforms of 1991, maximum efforts ha"e been made to boost the

in"estors confidence by ma!ing the trading process more users friendly 'till,

there are some issues in this mar!et 'o, the present paper is an attempt to study the


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'ection acD of 'ecurities Contract >egulation $ct 'C>$D 19G defines

5eri"ati"e as< aD Ha security deri"ed from a debt instrument, share, loan whether

secured or unsecured, ris! instrument or contract for differences or any other form

of securityB bD Ha contract which deri"es its "alue from the prices, or index of

prices, of underlying securitiesJ %he International (onetary *und 001D defines

deri"ati"es as Hfinancial instruments that are lin!ed to a specific financial

instrument or indicator or commodity and through which specific ris!s can be

traded in financial mar!ets in their own right %he "alue of a financial deri"ati"e

deri"es from the price of an underlying item, such as an asset or index Knli!e debt

securities, no principal is ad"anced to be repaid and no in"estment income

accruesJ

articipants in t#e derivative mar!et:

Eatwari and 7harga"a 00D stated that there are three broad categories of

participants in the deri"ati"e mar!et %hey are< edgers, 'peculators and

$rbitrageurs $ edger is a trader who enters the deri"ati"e mar!et to reduce a

pre+ existing ris! In India, most deri"ati"es users describe themsel"es as hedgers

*itch >atings, 00AD and Indian laws generally re#uire the use of deri"ati"es for

hedging purposes only 'peculators, the next participant in the deri"ati"e mar!et,

buy and sell deri"ati"es to boo! the profit and not to reduce their ris! %hey wish to

ta!e a position in the mar!et by betting on future price mo"ement of an asset

'peculators are attracted to exchange traded deri"ati"e products because of their

high li#uidity, high le"erage, low impact cost, low transaction cost and default ris!beha"ior *utures and options both add to the potential gain and losses of the

speculati"e "enture It is the speculators who !eep the mar!et going because they

bear the ris!s, which no one else is willing to bear


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%he third participant, $rbitrageur is basically ris!+a"erse and enters into the

contracts, ha"ing the potential to earn ris!less profits It is possible for an

arbitrageur to ha"e ris!less profits by buying in one mar!et and simultaneously

selling in another, when mar!ets are imperfect long in one mar!et and short in

another mar!etD $rbitrageurs always loo! out for such price differences

$rbitrageurs fetch enormous li#uidity to the products which are exchanges traded

%he li#uidity in+turn results in better price disco"ery, lesser mar!et manipulation

and lesser cost of transaction

$ccording to (urti 000, Hthe hedgers, the speculators and the arbitrageurs all

three must co+exist In simple words, all the three type of participants are re#uired

not only for the healthy functioning of the deri"ati"e mar!et, but also to increase

the li#uidity in the mar!et %he mar!et would become mere tools of gambling

without the hedgers, as they pro"ide economic substance to the mar!et

'peculators pro"ide depth and li#uidity to the mar!et $rbitrageurs help price

disco"ery and bring uniformity in prices

0iterature Review

$ccording to @reenspan 1993D H7y far the most significant e"ent in finance

during the past decades has been the extraordinary de"elopment and expansion of

financial deri"ati"esTJ $"adhani 000D stated that a deri"ati"e, an inno"ati"e

financial instrument, emerged to protect against the ris!s generated in the past, as

the history of financial mar!ets is repleted with crisesD )"ents li!e the collapse of

the fixed exchange rate system in 1931, the 7lac! (onday of -ctober 19.3, the

steep fall in the 8i!!ei in 19.9, the K' bond debacle of 199A, occurred because of

"ery high degree of "olatility of financial mar!ets and their unpredictability 'uch

disasters ha"e become more fre#uent with increased global integration of mar!ets


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'ahoo 1993D opines H5eri"ati"es products initially emerged, as hedging de"ices

against fluctuation in commodity prices and the commodity+lin!ed deri"ati"es

remained the sole form of such products for many years (arlowe 000D argues

that the emergence of the deri"ati"e mar!et products most notably forwards,

futures and options can be traced bac! to the willingness of ris!+a"erse economic

agents to guard themsel"es against uncertainties arising out of fluctuations in asset

prices

It is generally stated that regulation has an important and critical role to ensure the

efficient and smooth functioning of the mar!ets $ccording to 'ahoo 1993D the

legal framewor! for deri"ati"es trading is a critical part of o"erall regulatory

framewor! of deri"ati"e mar!ets %he purpose of regulation is to encourage the

efficiency and competition rather than impeding it athaway 199.D stated that,

while there is a percei"ed similarity of regulatory ob&ecti"e, there is no single

preferred model for regulation of deri"ati"e mar!ets 5eri"ati"es include a wide

range of financial contracts, including forwards, futures, swaps and options

*orward contract is an agreement between two parties calling for deli"ery of, andpayment for, a specified #uantity and #uality of a commodity at a specified future

date %he price may be agreed upon in ad"ance, or determined by formula at the

time of deli"ery or other point in timeJ Web D Fust li!e other instruments, it is

used to control and hedge currency exposure ris! eg forward contracts on K'5

or )K>D or commodity prices eg forward contracts on oilD Eatwari and

7harga"a 00D explain it in simple words and further add that one of the parties

to a forward contract assumes a long position and agrees to buy the underlying

asset at a certain future date for a certain price and the other agrees to short it %he

specified price is referred to as the deli"ery price %he parties to the contract

mutually agree upon the contract terms li!e deli"ery price and #uantity


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WebA states that H$ *utures Contract is a standardized contract, traded on a

futures exchange, to buy or sell a certain underlying instrument at a certain date in

the future, at a pre+set price %he future date is called the deli"ery date or final

settlement date %he pre+set price is called the futures price %he price of the

underlying asset on the deli"ery date is called the settlement price %he futures

price, naturally, con"erges towards the settlement price on the deli"ery dateJ

'irisha 001D explain the %ypes of *utures which are as followseser"e 7an! of India, *orward (ar!ets commission, the

'ecurities and )xchange 7oard of India, and the 5epartment of Company affairs

etc

Stren,t#enin, t#e Centrali(ed Clearin, arties: CCI:, which started

functioning in 00, is the only centralized clearing party for trade processing and

settlement ser"ices in India It currently pro"ides a guaranteed settlement facility

for go"ernment securities trading, clearing of collateralized borrowing and lending

obligations C7:-D, guaranteed settlement of foreign exchange trading, and

settlement of all Indian >e"enue 'er"ice I>'D %hough the concentration of

business relating to money, securities and forex mar!ets with the CCI: helps inpooling ris!s and reducing the o"erall transactions costs for the system, the

Certified *inancial 'er"ices $uditors C*'$D report opined that the concentration

of such a wide spectrum of acti"ities leads to concentration of ris!s in one entity

%herefore, there is the need to strengthen more and more clearing parties

"a* and 0e,al bottlenec!s:In India, at present there are tax restrictions on the

mo"ement of certain goods from one state to another %hese need to be remo"ed sothat a truly national mar!et could de"elop for commodities and deri"ati"es $lso,

regulatory changes are re#uired to bring about uniformity in octroi and sales taxes

etc O$% has been introduced in the country in 00G, but has not yet been

uniformly implemented by all states


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-ew )erivatives roducts for Credit Ris! "ransfer >CR"@: Credit ris!

transfer C>%D, in a broad sense including guarantees, loan syndication, and

securitizationD,has a long history owe"er, there has been a sustained and rapid

growth of new and inno"ati"e forms of C>% associated with credit deri"ati"es %he

most common credit deri"ati"es are credit default swaps C5'D on single

corporate entity single+name C5'D and collateralized debt obligations C5-sD

'ince 00G, C>% acti"ity became significant for two additional underlying asset

classes asset bac!ed securities $7'D and le"eraged loans Internationally, ban!s

and financial institutions are able to protect themsel"es from credit default ris!

through the mechanism of credit deri"ati"es owe"er, credit deri"ati"es were not

allowed in India until recently %he >7I has made an announcement in its second+

#uarter monetary policy 009+10 that it has considered it appropriate to proceed

with caution on this issue %o start with Ist 5ecember 011, >7I has introduced

guidelines for a basic, o"er+the+counter, single name C5' for corporate bonds for

resident entities, sub&ect to safeguards

R$CO$-)A"IO-S A-) S.4$S"IO-S

>7I should play a greater role in supporting deri"ati"es

5eri"at i"es mar!et should be de"eloped in order to !eep i t a t

par with other deri"ati"e mar!ets in the world

'peculation should be discouraged

%here must be more deri"ati"e instruments aimed at indi"idual in"estors

')7I should conduct seminars regarding the use of deri"ati"es to educate

indi"idual in"estors


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$fter study it is clear that 5eri"ati"e influence our Indian )conomy

upt o m u c h e x t e n t ' o , ' ) 7 I s h o u l d t a ! e

n e c e s s a r y s t e p s f o r impro"ement in 5eri"ati"e (ar!et so that

more in"estors can in"est in 5eri"ati"e mar!et

%here is a need of more inno"ation in 5eri"ati"e (ar!et because in

t od a y s c en ar io e "e n e du c at ed p eo pl e a ls o f ea r f o r

i n " e s t i n g i n 5eri"ati"e (ar!et 7ecause of high ris! in"ol"ed in

5eri"ati"es

Conclusion:%he Indian deri"ati"e mar!et has achie"ed tremendous growth

o"er the years, and also has a long history of trading in "arious deri"ati"es

products %he deri"ati"es mar!et has seen ups and downs %he new and

inno"ati"e deri"ati"e products ha"e emerged o"er the time to meet the

"arious needs of the different types of in"estors %hough, the deri"ati"e

mar!et is burgeoning with its di"ergent products, yet there are many issues

$mong the issues that need to be immediately addressed are those related to,

lac! of economies of scale, tax and legal bottlenec!s, increased off+balance

sheet exposure of Indian ban!s, need for an independent regulator etc

'olution of these issues will definitely lead to boost the in"estors

confidence in the Indian deri"ati"e mar!et and bring an o"erall de"elopment

in all the segments of this mar!et

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