Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the world’s largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.

In the equity markets, a system of trading called “badla” involving some elements of forwards trading had been in existence for decades. However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

Derivatives Instruments Traded in India

In the exchange-traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively.

Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become equally popular to the index futures. In fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock futures globally, enabling it to highest rank holder among world exchanges at point of time. While single stock options were less popular than stock futures, they have witnessed a high growth rate since starting of 2011 after they were changed to European style. On the other hand, index options are hugely popular than index futures. Now a days, index options turnover share the 2/3rd of the total F&O turnover. NSE launched interest rate futures in 2009 on 10 Year Notional Coupon-bearing Govt. of India Security & the recently introduced (2011) 91-day Govt. of India T-Bill; but in contrast to equity derivatives, there has been little trading in them. This particular segment is still in its nascent stage.

Regulators permitted the exchanges to launch currency derivatives contracts to start with USDINR currency pair in 2nd half of 2008. Later on three more currency pairs EURINR, GBPINR & JPYINR is allowed in Feb. 2010. Currency options contracts were launched on Oct. 29th 2010 on USDINR only & so far now this is the only option contract available in the segment. Since its launch forex derivatives have seen continuous activity & rising trading volumes than interest rate derivatives and any other segments.

Exchange-traded commodity derivatives have been allowed for trading only since April 2003. The number of commodities eligible for futures trading is 109 by 2011 on 21 recognized exchanges. Of all the commodities, bullion contracts shares 40.75%, most of the total turnover. Among all exchanges, MCX enjoys the biggest share of turnover of more than 82% of the total traded value.

Synopsis of Derivatives

A derivative instrument is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.

Rise of Derivatives

The global economic order that emerged after World War II was a system where many under developed countries administered and controlled prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates for currencies/foreign exchange.

The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate as per demand and supply. Under developed countries like India began opening up their economies and allowing prices to vary with market conditions in early 90’s with start of economic liberalisation process and RBI started playing little role in controlling the foreign exchange prices.

Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provided them a valuable set of tools for managing this risk.

Uses of Derivatives

Derivatives may be traded for a variety of reasons. A derivatives contract enables a trader to hedge some market risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market.

Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.

A third type of trader, called arbitrageurs, profit from discrepancies or mispricing in the relationship of spot and derivatives prices, and thereby help to keep markets efficient.

Exchange-Traded and Over-the-Counter Derivative Instruments

India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous electronic trading, a predominantly retail market and an active regulatory framework. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery.

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “hawala” or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the exchanges trading derivatives as per present market structure in India. Margin requirements and daily marking-to-market of futures positions substantially mitigate the credit risk of exchange-traded contracts, relative to OTC contracts.

Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence. Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.

Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives.

Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. In practice, some foreign investors also invest in Indian markets by issuing Participatory Notes to an off-shore investor. FIIs have a significant and increasing presence in the equity derivatives markets. They have no incentive to trade interest rate derivatives since they have little investments in the domestic bond markets.

Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors’ prior familiarity with “badla” trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the markets for commodity derivatives, due in part to their long-standing expertise in trading in the “hawala” or forwards markets.

Summary and Conclusions

In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets. While the growth is being spearheaded by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding.

In the past, there were major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures showed that almost 90% of activity was due to index options, index futures & stock futures, whereas trading in options is limited to a few stocks, partly because stock options were of American style & they are settled in cash and not the underlying stocks. But with the start of 2011 all stock options available for trading were changed to European style. This change has led to the liquidity in stock options not only close to ATM strikes but also across multiple strikes just as in case of index options. This change has encouraged the options writers to go ahead eliminating the assignment risk prior to expiry which will eventually benefit them.

Considering these changes derivatives market in India is poised to grow and mature further to accommodate larger participation across varied asset classes by wide range of participants.

Types of Mutual Fund Schemes in India

Mutual funds have wide variety of schemes to cater the needs such as financial position, risk tolerance and return expectations etc. Availability of plethora of schemes and each scheme being a collection of many investment options, an investor can be easily confused in picking a right mutual fund as per his/her needs. There are over hundreds of mutual funds schemes to choose from & to select the appropriate one it would be easier to first categorize mutual funds in below mentioned framework:

A: BY STRUCTURE

1. Open - Ended Schemes

An open-ended fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices. The key feature of open-ended schemes is liquidity.

2. Close - Ended Schemes

These schemes have a pre-specified maturity period. One can invest directly in the scheme at the time of the initial issue. Depending on the structure of the scheme there are two exit options available to an investor after the initial offer period closes. Investors can transact (buy or sell) the units of the scheme on the stock exchanges where they are listed. The market price at the stock exchanges could vary from the net asset value (NAV) of the scheme on account of demand and supply situation, expectations of unit holder and other market factors. Alternatively some close-ended schemes provide an additional option of selling the units directly to the Mutual Fund through periodic repurchase at the schemes NAV; however one cannot buy units and can only sell units during the liquidity window. SEBI Regulations ensure that at least one of the two exit routes is provided to the investor.

3. Interval Schemes

Interval Schemes are that scheme, which combines the features of open-ended and close-ended schemes. The units may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV related prices.

B: BY NATURE

1. Equity fund

These funds invest a maximum part of their corpus into equities holdings. The structure of the fund may vary for different schemes and the fund manager’s outlook on different stocks. The Equity Funds are sub-classified depending upon their investment objective, as follows:

·         Diversified Equity Funds

·         Mid-Cap Funds

·         Sector Specific Funds

·         Tax Savings Funds (ELSS)

Equity investments are meant for a longer time horizon, thus Equity funds rank high on the risk-return matrix.

2. Debt funds

The objective of these Funds is to invest in debt papers. Government authorities, private companies, banks and financial institutions are some of the major issuers of debt papers. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Debt funds are further classified as:

·         Gilt Funds: Invest their corpus in securities issued by Government, popularly known as Government of India debt papers. These funds carry zero default risk but are associated with interest rate risk. These schemes are safer as they invest in papers backed by Government.

·         Income Funds: Invest a major portion into various debt instruments such as bonds, corporate debentures and Government securities.

·         MIPs: Invests maximum of their total corpus in debt instruments while they take minimum exposure in equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the risk-return matrix when compared with other debt schemes.

·         Short Term Plans (STPs): Meant for investment horizon for three to six months. These funds primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate debentures.

·         Liquid Funds: Also known as Money Market Schemes, These funds provides easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, Inter-Bank Call Money Market, CPs and CDs. These funds are meant for short-term cash management of corporate houses with investment horizon of 1 day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds.

3. Balanced funds

As the name suggest they, are a mix of both equity and debt funds. They invest in both equities and fixed income securities, which are in line with pre-defined investment objectives of the scheme. These schemes aim to provide investors with the best of both the worlds. Equity part provides growth and the debt part provides stability in returns.

Further the mutual funds can be broadly classified on the basis of investment parameter:

Each category of funds is backed by an investment philosophy, which is pre-defined in the objectives of the fund. The investor can align his own investment needs with the funds objective and invest accordingly.

By investment objective

·         Growth Schemes: Growth Schemes are also known as equity schemes. The aim of these schemes is to provide capital appreciation over medium to long term. These schemes normally invest a major part of their fund in equities and are willing to bear short-term decline in value for possible future appreciation.

·         Income Schemes: Income Schemes are also known as debt schemes. The aim of these schemes is to provide regular and steady income to investors. These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited.

·         Balanced Schemes: Balanced Schemes aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. These schemes invest in both shares and fixed income securities, in the proportion indicated in their offer documents (normally 50:50).

·         Money Market Schemes: Money Market Schemes aim to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer, short-term instruments, such as treasury bills, certificates of deposit, commercial paper and inter-bank call money market.

Other schemes

·         Tax Saving Schemes:

Tax-saving schemes offer tax rebates to the investors under tax laws prescribed from time to time. Under Sec. 88 of the Income Tax Act, contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.

·         Index Schemes:

Index schemes attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE 50. The portfolio of these schemes will consist of only those stocks that constitute the index. The percentage of each stock to the total holding will be identical to the stocks index weightage. And hence, the returns from such schemes would be more or less equivalent to those of the Index.

·         Sector Specific Schemes:

These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. The returns in these funds are dependent on the performance of the respective sectors/industries. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time.

History of Indian Mutual Fund Industry

The idea of Mutual Fund had its formal origin in Belgium as investments in national industries associated with high risks. In 1860s this movement started in England. In 1868, the foreign and Colonial Government Trust was established to spread risks for investors over a large number of securities. In USA the idea took root in the beginning of the 20^th century. In Canada, during 1920, many close ended investment companies were organized. The first mutual fund in Canada to issue its share to general public was the Canadian Investment Fund (1932). Large number of mutual funds emerged and expanded their wings in the many countries in Europe, the Far East countries and Latin America. Countries in Pacific area like Hong Kong, Thailand, Singapore and Korea have also entered this field in a long way.

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank of India. The history of mutual funds in India can be broadly divided into four distinct phases

First Phase – 1964-87 (Establishment & Growth of UTI)

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI.

The first scheme launched by UTI was Unit Scheme 1964, which attracted the largest number of investors in any single investment scheme over the years. UTI launched more innovative schemes in 1970s and 80s to suit the needs of different investors. It launched ULIP in 1971, six more schemes during 1981-84, Children's Gift Growth Fund and India Fund (India's first offshore fund) in 1986, Mastershare (India’s first equity diversified scheme) in 1987 and Monthly Income Schemes (offering assured returns) during 1990s. Since establishment UTI enjoyed complete monopoly and by the end of 1987, UTI's assets under management grew ten times to Rs. 6700 crores.

Second Phase – 1987-1993 (Entry of Public Sector Funds)

The Indian mutual fund industry witnessed a number of public sector players entering the market in 1987 including public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non-UTI Mutual Fund established in June 1987 followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in June 1989 while GIC had set up its mutual fund in December 1990.

At the end of 1993, the mutual fund industry had assets under management increased by seven times to Rs. 47,004 crores. However, UTI remained to be the leader with about 80% market share.

Third Phase – 1993-2003 (Entry of Private Sector Funds)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of ` 1,21,805 crores. The Unit Trust of India with ` 44,541 crores of assets under management was way ahead of other mutual funds.

Fourth Phase – since February 2003

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of ` 29,835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than ` 76,000 crores of assets under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth.

In this phase, the mutual fund industry witnessed several merger & acquisitions and simultaneous entry of international mutual fund players like Franklin Templeton, Fidelity, DSP BlackRock, HSBC, JP Morgan, Mirae Asset, AIG Global etc.

The industry witnessed a compounded annual growth rate of 31.25% from March 2003 to March 2011. The graph indicates the growth of assets over the years.