5 Market Structure and Governance

5.1 Separation of cash and derivatives markets

The LCGC discussed the issue of separation of the cash and derivative markets at length:

“The Committee examined the relative merits of allowing derivatives trading to be conducted by an existing stock exchange vis-à-vis a separate exchange for derivatives. The arguments for each are summarised below.

Arguments for allowing existing stock exchanges to start futures trading:

(a) The most weighty argument in this regard is the advantage of synergies arising from the pooling of costs of expensive information technology networks and the sharing of expertise required for running a modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more time.

(b) The recent trend in other countries seems to be towards bringing futures and cash trading under coordinated supervision. The lack of coordination was recognised as an important problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level supervisory coordination between futures and cash markets is greatly facilitated if both are parts of the same exchange.

Arguments for setting-up separate futures exchange:

(a) The trading rules and entry requirements for futures trading would have to be different from those for cash trading.

(b) The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange.

(c) A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players.” (Paragraph 3.7)

“From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below…” (Paragraph 3.8)

The ACD has also discussed this matter extensively. The committee noted that one of the major considerations of the LCGC in recommending a separate derivatives segment was the desire to “start with a clean slate” without being bound by the trading rules and practices of the cash segment. The Committee also noted that the LCGC’s recommendations were made keeping in mind the circumstances prevalent during the period in which it conducted its deliberations (The LCGC was formed in 1996 and submitted its report in 1998). Since then, there have been significant changes with regard to the governance of Exchanges and the structure of the markets. The ACD also noted that in many areas, the procedures and practices in the derivative segment are being adopted in the cash segment. Moreover, internationally, different markets like equity, derivatives and debt are merging to achieve efficiency in operations and to reduce cost of transactions.

The Committee considered the desirability of separation in three different areas:

1. In certain areas like risk management and surveillance a ‘one market concept’ should be followed and these areas would have to be administered by taking an overall exposure of members / client across all segments of the Exchange. Separation was undesirable in these areas.

2. In certain areas, the desirability of separation needs further analysis and discussion. For example, it could be argued that the ‘Trade Guarantee Fund (TGF) / Settlement Guarantee Fund (SGF)’ should be separate so that the risk of one market does not affect the risk of the other market and also because the fact that all the members of cash segment are not the members of the derivative segment. But it could also be argued that merging or pooling of funds in the TGF/SGF across different market segments would in fact strengthen the Clearing Corporation. Moreover, since many members of the cash segment are now becoming members of the derivative segment, TGF/SGF of cash and derivatives could also be considered for merger. Similarly, the desirability of having separate membership, bylaws and governing boards also needs further discussion. The Committee decided that these issues could be taken up for review at a later stage and that till then the current situation should continue.

3. In certain areas like personnel, administration and infrastructure, the Committee was of the view that it should be left to the Exchanges to decide whether to have separation or not.

After deliberation the committee recommended that SEBI should only be concerned with separation of legal architecture of the derivative segment by ensuring separate Bye-laws, Rules, Regulations, Governing Council & membership. The functional, operational and administrative modalities should be left to the discretion of the exchanges. The cash and derivative segments could have common personnel, trading terminal and infrastructure. The committee specified the areas in the derivative segment which should be separate from the cash segment for the present. These are as under:-

• The legal framework governing trading, clearing & settlement of the Derivative segment should be separate form the cash market segment. In other words, the Regulations & Bye-laws of derivative segment, as the case may be for specific exchanges, should be separate.

• TGF/SGF of the derivative segment should be separate form the cash market segment and merging / pooling of TGF/SGF may be considered at a later date.

• Membership of the derivative segment should be separate from the cash market segment.

• The Governing Council / Clearing Council / Executive Committees of the derivative segment should be separate from the cash market segment.

5.2 Sub brokers

The LCGC Report made no mention of sub brokers though it recommended a two tier market structure consisting of trading members and trading members.

The ACD has discussed the issue of sub brokers on several occasions. Its view has consistently been that there can be no compromise on

(a) client level gross margins

(b) regulation of sales practices at client level.

Sub brokers as they operate in cash market are inconsistent with this. However, the ACD has consistently taken the view that other forms of multi-tier broking relationships are possible consistent with the above two requirements.

• The Trading member – Clearing Member structure itself is two-tier structure and the regulatory regime imposes no minimum capital requirement on trading members as the clearing member is responsible for all settlement obligations. It is therefore possible for a sub broker to be registered as a trading member with fairly low capital requirements. The ACD has also been of the view that exchanges should be allowed to use any terminology that they like for such sub-broker turned trading member so long as they are registered with SEBI as trading members.

• It is also possible to adopt a remisier model in which client of the sub broker receive contract notes issued in the name of and on behalf of the main broker.

The ACD is of the view that SEBI should be open to any proposal from the exchanges for assimilating sub brokers into the market structure so long as these are consistent with the twin requirements of client level gross margins and regulation of sales practices at client level.

5.3 Inspection

The LCGC recommended 100% inspection of all derivative brokers every year:

“The Committee also feels that every derivative trader/member (not just 10 per cent of them) should be inspected by the derivative exchange annually, both to provide guidance in the initial years and to check compliance. This is particularly important at the initial stage of derivatives trading. The derivative exchange should be required to have a strong inspection department. Its staff should be given specialised training for the purpose.” (Paragraph 4.6)

The advisory committee reviewed the recommendation of 100% inspection of trading / clearing members in a year by the LCGC. The committee was informed that while reviewing the functioning of derivative segment of the two exchanges (NSE and BSE), SEBI had observed that in an effort to complete 100% inspection the quality of inspection was being compromised. The Exchanges also agreed with the observation of SEBI and requested that the condition of 100% inspection be done away with as it is practically difficult to inspect all members irrespective of their share in the total trading in the market.

The advisory committee after deliberating on the issue was of the view that inspection should be linked to the level of activity of the member and other criteria as the circumstances demand. The committee was of the view that condition of 100% inspection may be done away with and the quantum of members to be inspected could be linked to the cost and benefit of inspections and the criteria decided in this regard. The Exchange should work out an appropriate inspection strategy in consultation with SEBI. This inspection strategy should lay down:

• the criteria for identifying the top members to be taken up for 100% inspection

• the percentage of remaining members to be inspected on a sampling basis

• mechanisms to ensure that active members do not go uninspected for several years in succession

5.4 Surveillance

The committee also deliberated on the issues which would be covered in the Surveillance Systems / Mechanism in the derivative markets. While many aspects of surveillance would be the same for derivatives and for other securities, the committee felt that some areas of differences do exist. In particular, the Committee is of the view that the exchanges should consider developing a specific stock watch system for derivative markets. The cash market surveillance mechanism may not meet all the requirements of the derivatives market. Some of the important issues that arise are as follows:

• There should be monitoring of open interest, cost of carry, impact cost, and volatility. The open positions in the derivative market should be seen in conjunction with the open positions in the cash market i.e. the position deltas should be monitored.

• The timing of information disclosure by corporates should be monitored as this could influence the prices of the contract at the time of contract introduction and expiry.

• Strike prices with large open positions should be monitored as such strike prices could be a target price to be achieved in the cash market to derive maximum benefit from the derivative position.

• It is also necessary to monitor contract expirations very carefully. The ACD has sometimes reviewed this on an ad hoc basis. For example, in one of its meetings, it reviewed the contract expirations coinciding with large volumes and high volatility on February 28, 2002 (budget announcement) and March end (close of.27 the financial year). Both BSE & NSE submitted details of the analysis that they had carried out in this regard and stated unequivocally that there were no risk management or market integrity concerns associated with these expirations. Expiration monitoring should be done systematically from a surveillance point of view.

• Unified surveillance of the cash and derivatives markets is essential both at the exchange level and at the level of SEBI.

• SEBI and the Exchanges should study surveillance practices in various global equity derivative markets. Surveillance practices in global commodities and bullion derivative markets could also be studied where appropriate as some of the well publicized cases of market manipulation in derivatives have been in these markets. Case studies on some market manipulations in various derivatives markets could be looked at to see what lessons could be drawn.

5.5 Physical Settlement

The LCGC Report took it for granted that physical settlement would be used for derivative contracts on individual stocks:

“In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere.” (Paragraph 2.8(5))

However, when single stock derivatives were introduced in India, it was decided to use cash settlement to begin with because the exchanges did not then have the software, legal framework and administrative infrastructure for physical settlement. It was proposed that cash settlement would be replaced by physical settlement within a period of six months as the exchanges developed the capabilities to achieve physical settlement efficiently.

In April 2002, the ACD proposed a broad framework for physical settlement. The SEBI Board desired that the committee should present a report highlighting the risks and benefits of physical settlements along with possible risk containment measures.

Accordingly, the ACD reconsidered its recommendation on the risks and benefits of physical settlement. The ACD notes the principal issues involved in physical settlement:

· In the absence of a vibrant mechanism for securities lending and borrowing, physical settlement of stock specific derivative contracts, especially stock options, may raise concerns on the possibility of a short squeeze.

· Globally, cash settlement is cheaper than physical settlement, but the economics may be less clear cut in India where the modernization of the payment system has lagged that of the securities settlement system.

· Under the existing procedure of cash settlement, hedgers and arbitrageurs incur overnight price risk for liquidating one leg of the transaction in the cash markets.A hedger (who by definition has a position in the underlying) would have to liquidate that position in the cash market and then bears the risk that the price realized in the cash market would differ from the settlement price used for cash settlement in the derivative markets. The same argument applies to arbitrageurs. Speculators on the other hand would find cash settlement beneficial since they do not (by definition) have an offsetting cash market position and cash settlement saves them the burden of operating in two markets. Physical settlement of derivative contract helps hedgers and arbitragers avoid basis risk while imposing some additional costs on speculators.

The committee is of the view that the regulatory regime should be more in tune with the requirements of hedgers and arbitrageurs than the needs of speculators. For this reason, it recommends physical settlement which protects hedgers and arbitrageurs from basis risk in the settlement process 8 . At the same time, the Committee recognizes the concerns regarding short squeezes in physical settlement. To address these concerns, the committee recommends the following measures to reduce the risk of short squeeze:

• The exchanges should lay down limits on daily exercise and assignment of stock options. Since these options are American, the squeeze can arise at any time during the contract cycle. Daily limits on exercise and assignment limit the ability to squeeze the market in the middle of the contract month.

• That leaves the possibility of a short squeeze at expiry. One important defence against this is the position limits that apply in the derivative market. In fact, market manipulation can take place even under cash settlement and position limits are the principal defence available to the regulator.

• The Committee also believes that there is greater need for surveillance as the contract approaches expiry. Large positions tend to be closed out or rolled over into the next contract month as the contract approaches expiry. Large positions that are maintained or enhanced during the last days of the life of the contract need to be monitored closely.

• Greater availability of information is another powerful force to guard against market manipulation (regardless of whether the settlement is cash or physical). Information on large positions must be disclosed to the market on a regular basis and the exchanges should be empowered and encouraged to disclose information in greater detail especially towards contract expiry.

The committee therefore recommends that derivatives on individual stocks should shift to physical settlement. The committee also recommends that physical settlement be implemented for all stock based derivative product simultaneously by giving at least 45 days notice to the market. However, Mr. Vaidyanath stated that the BSE is apprehensive of short squeezes in absence of efficient stock borrowing and lending mechanism and would like the choice of implementing physical settlement to be left to the exchange.

As regards the mechanism of physical settlement, three different models appear to be prevalent globally:

1. At one extreme is the system of completely separate and independent settlement processes for derivatives and cash equities. This might be a reasonable description of the London Clearing House (LCH)’s independent settlement processes for Liffe and LSE. However, LCH settlement systems have been continuously evolving and LSE/LCH started net settlement of cash equities only recently.

2. Use cash market transactions to settle derivatives. This might be a reasonable description of what MEFF does in Spain. In this model, every derivatives member must appoint a cash market member to carry out the execution of cash market transactions deriving from the exercise or settlement of derivative contracts traded by it for itself or on behalf of its clients.

3. Use cash market clearing corporation to settle derivatives. This might be a reasonable description of what the Option Clearing Corporation (OCC) does in the US. Under this model, settlement obligations among derivative market members resulting from the exercise or settlement of derivatives are discharged through a cash market clearing corporation. The OCC carries this model further by stipulating that “When an exercise is submitted to a stock clearing corporation for settlement and not rejected by it, the responsibility for completing the settlement passes from OCC to the stock clearing corporation. … After that time, OCC has no further responsibility to its Clearing Members for the exercise. Instead, rights and responsibilities run between the exercising and assigned Clearing Members and the stock clearing corporation” (OCC, Rule 913).

The ACD is of the view that the first model (completely separate settlement) would require a duplication of the entire settlement infrastructure in the derivatives market clearing corporation without any attendant benefits. At the same time, the second model (settlement through cash market transactions) commingles the cash and derivative markets and is undesirable as the cost and efficiency benefits of that model could be achieved by intertwining the two clearing corporations rather than the two markets themselves.

Accordingly, the ACD recommends the third model: the mechanism of physical settlement should be such that at no point in time are trades on the derivative segment commingled with trades on cash market. However, the clearing corporation 9 of the derivative segment could use the facility of the clearing corporation of cash market as its agent.

This would neither dilute the guarantee mechanism nor would it cast a burden on Trade guarantee fund of the other segment. The role of clearing corporation of derivative segment and clearing corporation of the cash segment would be defined in an agreement/arrangement which could be in line with the agreement between the various clearing corporations which are carrying out clearing between two markets internationally.

The committee considered the need of reducing the cost of transaction by giving margin benefit in the case of offsetting position in cash and derivative market. The committee was of view that it would be better to implement cross margining in cash and derivative market instead of merging the trades in cash and derivative market. The recommendations in this regard are outlined in 4.2. However, until full fledged cross margining is adopted, there should be a margin offset only for deliverable positions.

In the light of the above broad policy framework, committee recommends the following operational parameters for physical settlement:

• Clearing Corporation of the cash market would act as an agent of the clearing corporation of the derivative segment, for clearing the exercised / expired stock option and stock futures contracts. The delivery obligation at the Trading Member level in the derivative markets would be settled through the cash market clearing corporation as per the delivery mechanism prevalent in the cash market clearing corporation.

• The trading member of the derivative market would enter into an agreement/arrangement with a clearing member of the cash market and such clearing member of the cash market would act as an agent of the trading member/clearing member of the derivative market for the purpose of settling the delivery obligation of such member.

• The Clearing Corporations of the Cash segment and the Derivative segment may enter into an agreement/arrangement which could address the issues of risk management, cross margining system, and the other concerned areas. In the event of default the proportion in which the burden of default would be shared between the Settlement Guarantee Funds of cash and derivative segment, could also be specified in the agreement/arrangement.

• Similarly, a tripartite agreement between the client, the trading member of derivative segment and the clearing member of the cash segment could be entered which could specify issues pertaining to delivery offsets, margin requirement and any other concerned issue.

• The delivery obligation of the derivative segment would be netted at Trading Member level and passed on to the clearing member of the cash market for settlement as an agent.

• To allow option writers to deliver stock in time, one day’s notice shall be given for the exercise of options. On exercise, the delivery would be settled in the time frame specified in the cash market.

• The margin set off at the client level would be made available by adopting the cross margining between the clearing corporation of derivatives segment and the cash segment as outlined in 4.2.

• The ‘effective date’ from which stock futures and stock option contracts change to physical settlement mode should coincide with the date of inception of a new contract month. From the ‘effective date’ the outstanding stock futures and stock option contracts, would also change to physical settlement, though at inception, these contracts were stated to be for cash settlement.

• The ‘effective date’ for physical settlement should be announced 45 days in advance.  

    
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