FIIs and Derivatives

Are FIIs allowed to invest in derivatives?

Yes, FIIs are allowed to invest in equity derivatives as per SEBI guidelines. SEBI had issued a circular on 12^th Feb 2002 wherein the regulations in this regard have been specified.

Initial RBI approval

RBI had vide circular EC.CO.FII/ /11.01.01(16)/2000-01 dated August 7, 2000 permitted FIIs to trade in exchange traded index futures contracts on the Derivative Segment of BSE and the F & O Segment of NSE provided the overall open interest of the FII would not exceed 100% of market value of the concerned FII's total investment

Further SEBI Guidelines

The SEBI Board vide meeting dated December 28, 2001 has permitted FIIs to trade in all exchange traded derivative contracts and laid down the position limits for the trading of FIIs and their sub-accounts. RBI vide circular ECO.CO.FII/515/11.01.01/(16) 2000-01 dated February 4, 2002 permitted FIIs to trade in all the exchange traded derivative contracts subject to the position limits prescribed hereunder. The FIIs shall be under obligation to adhere to the position limits prescribed for them and their sub-accounts. The FIIs shall also comply with the procedure for trading, settlement and reporting as prescribed by the derivative exchange / Clearing House / Clearing Corporation from time to time.

Position Limits

The position limits for FII and their sub-accounts shall be as under:

I POSITION LIMITS

At the level of the FII

• In the case of index related derivative products there shall be a position limit at the level of FII at 15% of the open interest of all derivative contracts on a particular underlying index or Rs. 100 crores whichever is higher, per exchange.

• The FII position limit in derivative contracts on a particular underlying stock would be at 7.5% of the open interest of all derivative contracts on a particular underlying stock or Rs. 50 crores whichever is higher, at an exchange.

At the level of the sub-account

• Each Sub-account of a FII would have the following position limits:

• A disclosure requirement for any person or persons acting in concert who together own 15% or more of the open interest of all derivative contracts on a particular underlying index.

• The gross open position across all derivative contracts on a particular underlying stock of a sub-account of a FII should not exceed the higher of:

• 1% of the free float market capitalisation (in terms of number of shares).

or

• 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts).

This position limits would be applicable on the combined position in all derivative contracts on an underlying stock at an exchange.

The Derivative Segment of the Exchanges and their Clearing House / Clearing Corporation would monitor the FII position limits at the end of each trading day. For this purpose, the Derivative Segment of the Exchanges and their Clearing House / Clearing Corporation would implement the following procedure for the monitoring of the FII and the sub-account's position limits: 

1. The FII would be required to notify the names of the Clearing Member/s and Custodian through whom it would clear its derivative trades to exchanges and their Clearing House / Clearing Corporation. 

2. A unique code would be assigned by the exchanges and / or the Clearing House / Clearing Corporation to each registered FII intending to trade in derivative contracts. 

3. The FII would be required to confirm all its positions and the positions of all its sub-accounts to the designated Clearing Members online but before the end of each trading day. 

4. The designated Clearing Member/s would at the end of each trading day would submit the details of all the confirmed FII trades to the derivative Segment of the exchange and their Clearing House / Clearing Corporation. 

5. The exchanges and their Clearing House / Clearing Corporation would then compute the total FII trading exposure and would monitor the position limits at the end of each trading day. The cumulative FII position may be disclosed to the market on a T + 1 basis, before the commencement of trading on the next day. 

6. In the event of an FII breaching the position limits on any derivative contract on an underlying, the FII would not be permitted by the exchanges and their Clearing House / Clearing Corporation / Clearing Member/s to take any fresh positions in any derivative contracts in that underlying. However, they would be permitted to execute off-setting transactions so as to reduce their open position. 

7. The FIIs while trading for each sub-account would also assign a unique client code with a prefix or suffix of the code assigned by the exchange and their Clearing House / Clearing Corporation to the FII. The FII would be required to enter the unique sub-account code before executing a trade on behalf of the sub-account. 

8. The sub-account position limits would be monitored by the FII itself, on the same lines as the trading member monitors the position limits of its client / customer. The FIIs would report any breach on position limits by the sub-account, to the derivative segment of the exchange and their Clearing House / Clearing Corporation and the FII / Custodian / Clearing Member/s would ensure that the sub-account does not take any fresh positions in any derivative contracts in that underlying. However the sub-account would be permitted to execute off-setting transactions so as to reduce its open position 

9. The exchanges may assign unique sub-account codes on the lines of unique client codes to each sub-account of a FII, which would enable the derivative segment of the exchange and their Clearing House / Clearing Corporation to monitor the position limits specified for sub-accounts.

II COMPUTATION OF THE POSITION LIMITS

The position limits would be computed on a gross basis at the level of a FII and on a net basis at the level of sub-accounts and proprietary positions.

The open position for all derivative contracts would be valued as the open interest multiplied with the closing price of the respective underlying in the cash market.

Have FIIs been active participants since Feb 2002?

FIIs were inactive during the whole of 2002 and for the first 5 months of 2003 also. The equity markets were during this phase passing through a dull phase. Once the markets started moving up smartly, FII action has emerged in the derivatives markets along with an increasing exposure in the cash market itself.

The current position of FIIs as of 20^th October 2003 is as under:

Source : www.sebi.gov.in

Open Interest positions of FIIs constitute 10 – 15% of the total market open interest positions these days. On 21^st October 2003, FII Open Interest constituted 15.71% of the total market open interest position (source www.nseindia.com).

Why this interest in derivatives?

Derivative volumes and consequential liquidity is interesting these days. Derivative volumes touch upwards of Rs 10,000 crores per day, which is higher than the cash market volumes of both exchanges NSE and BSE put together. Hence, entry and exit is easy for FIIs. Further, advantages of derivatives as available to individual investors is any way available to FIIs also, mainly the advantage of leverage.

The strength of the rupee is a great attraction for investing in Indian markets, directly in the cash segment as well as through the derivative segment.

Is there an arbitrage play by FIIs?

Yes, it does appear that FIIs are active players in cash and carry arbitrage.

How does that work?

FIIs will buy securities in the cash market and at the same time sell corresponding futures in the derivatives market. In bullish times, stock futures trade at a decent premium to the cash market. If the premium is 10% plus on an annualized basis, that is very interesting arbitrage to the FII community who do not find such rich pastures abroad. The strength of the rupee might in some cases further add to dollar earnings, but even if the rupee remains stable, the 10% return itself is very interesting to the FII community who might be able to typically borrow at 4% or downwards.

This has increased FII interest in derivatives to a great degree. No clear statistics are available as to how much of futures positions are covered by underlying stocks. As you can see, open positions in stock futures constitute more than 85% of the total open positions of FIIs in the derivatives segment. This data seems to suggest a preponderance of arbitrage transactions.

Would FIIs continue their participation in the derivatives segment in future?

So long as futures are quoted at reasonable premiums over cash market prices and FIIs see opportunities to earn upwards of 8% annualized, one can foresee a fairly healthy participation from their side. However, it is important to understand that futures differentials have not been always attractive if we look at the past 2 years of futures history. Till around May this year, futures were quoting at nominal differentials of 3-4% and in some cases, at a discount. If this scenario were to come back (once this bullishness subsides), then the arbitrage opportunity would also disappear or at least decrease. In such a situation, one would see FIIs reducing their derivatives exposures.

Is a high level of arbitrage operation good for the market?

High levels of arbitrage operations have their good and bad effects. Arbitrage will keep prices in check and bring discipline to futures markets. If futures were to move up sharply, they would be reined in by arbitrageurs so as to maintain a meaningful relationship vis-à-vis cash markets.

However, the downside could be in bear markets or stable markets. Once the differentials narrow down to uninteresting levels, the arbitrageurs would unwind their positions. Unwinding would imply that their long cash positions would not be sold. If a big selling wave emerges as a consequence of winding down (and as at last count, the values of such stocks could be of the order of Rs 2,600 crores), then these stocks would move down. Most of these stocks are likely to be majors with a significant role in the index and hence the market as a whole could be affected.

One therefore should be careful of hot money flowing into temporary arbitrage positions and disturbing the markets on exit.

Are the FIIs working on a better turf than their Indian brothers in this arbitrage?

Yes, the FIIs have access to cheaper funds and their cost could be 4% or even lower per annum. The Indian arbitrageurs inspite of the declining interest scenario in India over the last few years, would not be able to find funds at such low rates of interest. Thus, an 8% cash and carry differential might be interesting and rewarding to an FII which the same differential might be unexciting to an Indian. I think to this extent, FII artbirage operations will override their Indian counterparts in terms of volumes. This will lead to lesser opportunities for Indians because FIIs would snap up opportunities at 8% levels itself, leaving no scope for higher differentials which the Indians would be waiting for.

In a sense therefore, there is an uneven playing field in arbit operations, which might be beyond our control.

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