22 March 2009

Market skeptical of exotic derivatives

Market skeptical of exotic derivatives

Market participants appeared comfortable with the introduction of equity-linked exchange traded derivatives, but are skeptical about the ability to deal with exotic credit derivatives.

In addition, they said that the Securities and Exchange Board of India (Sebi) may need to upgrade its risk management and settlement systems to introduce trading in a host of new derivative instruments.

They said that the rules should be formulated in such a way that there was no room for manipulation in settlement of contracts and the margining system would need to be toned up.

On Friday evening, a committee on derivatives market review headed by Rammohan Rao, which had suggested at least 11 new instruments could be made available in the Indian market, also said that Sebi needed to ensure that systems were improved. For instance, entities trading in over-the-counter (OTC) contracts should have a net worth of at least Rs 500 crore.

“These products will pick up pace over a period of time if we launch them now. The crisis in the West was essentially created by the quality of credits and not because of these derivative products. In India, all such products are centrally traded on the exchanges, and the margins comfortably take care of related risks. We just have to ensure that no one should be able to manipulate settlements in such products,” an ICICI Prudential AMC executive said.

In fact, others such as Ambit Capital CEO-Equities Andrew Holland too said that the experience with the credit derivatives in developed markets like the United States should not act as a deterrent. “Sebi is considering many products which are equity-linked and that should not be a problem as it would be at a small level and can be controlled with proper risk management,” he said.

“Exotic derivative products will interest many foreign players and will also add depth to the Indian derivatives market. However, ensuring adequate risk mitigation and strengthening surveillance mechanisms will be one of the big challenges for the regulator as exotic derivative products have played a major role in worsening financial crises in US and Europe,” added Manish Sonthalia, V-P, equity strategy, Motilal Oswal Financial Services.

Market players said one of the first products which could enter India would be mini-contracts, which would be one-fifth or one-tenth in size compared with normal futures and options (F&O) contracts based on single stock or sectoral indices, comprising at least 15 scrips. At present, only Nifty and Sensex-based F&Os are traded. To facilitate higher appreciation in derivatives trading, the panel recommended F&Os of tenures up to five years, as against three years at present.

“Products like mini-contracts on single stocks will allow retail investors to participate in the F&O market. So far, many of them are unable to invest in these products due to a large contract size,” Reliance Money CEO Sudip Bandyopadhyay said, while adding that if the committee’s recommendations were accepted, it would help boost the options market that has been dormant so far.

Besides, there are suggestions to allow F&Os based on volatility index, and derivatives based on bond indices. The committee said a start could be made with a sovereign bond index for government securities, and a corporate bond index.

On the exotic products front, one recommendation was to allow exchange-traded cross-currency F&O contracts. These products are aimed at mitigating risks due to exchange rate fluctuations.

In addition, the committee proposed the launch of credit derivatives based on insurance against credit risks. The panel said that this will eventually help in better price discovery of corporate bonds and reduce counter-party risks taken through OTC credit derivative contracts.

“Exchange-traded products are more manageable than OTC products and these instruments take care of liquidity risks,” said Bandyopadhyay.

OTC products such as currency swaps, interest rate swaps, and structured notes, which are mostly traded among two entities without going through exchanges or intermediaries, were also recommended to provide a wide array of investment options. To begin with, the panel suggested that Sebi permit OTCs based on indexes and index-based F&Os. While equity-related derivatives might sound fine, the industry was skeptical of the impact of these products.

What's proposed What does it mean
Mini-contracts on single stock, sectoral scrips Low contract size, a boon for retail investors
Longer tenure options of up to 5 years Higher appreciation due to high price swings of underlying stock
F&O based on volatility index To improve liquidity
Options on currency, commodity, interest rate futures To improve liquidity in the market
Derivatives based on bond indices To improve liquidity in the market
Exchange-traded cross-currency F&Os To mitigate risk of exchange rate fluctuations, will help in hedging cross-currency deals
Credit derivatives based on insruance against credit risk Will result in better price discovery of corporate bonds, help hedge counter-party risk
OTC currency, forward rate swaps Will result in wider investment choices
Exchange-traded third-party structured products like calls and structured warrants Will improve liquidity of securities held by non-promoters

“India is not mature enough for these type of products,” said JSW Steel Director Seshagiri Rao MVS. “The intention is to reduce the risk, but if the complexity is not understood, then it would be more dangerous,” he added.

Source:Business Standard

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