Regulatory Issues In Derivatives Markets In India: Doing The ‘Right’ , and Not The ‘Easy’, Thing
V K Sharma, Former Executive Director, Reserve Bank of India
1. I deem it an honour and privilege to be addressing this very distinguished and august audience. Right at the outset, I would like to impress upon this very learned and discerning audience the proposition that the ‘financial sector’ is not an end in itself, but instead, it is a means to the end of sub-serving the ‘real sector’ and, in that sense, it is consistent with, and a natural fit to, the public policy imperative of “financial sector-real sector balance”. As this distinguished audience is aware, there is now a broad consensus and unanimity among all the key stakeholders that, in the run up to the the apocalyptic and cataclysmic global financial crisis of 2008 , the “financial sector”, what with the total notional amount of outstanding derivatives worldwide at US$ 675 trillion being 11 times the total world GDP of US$ 60 trillion, got to the point where, to all intents and purposes, instead of being a means to the end of sub-serving the “real sector”, it came to exist, almost entirely for its own sake, to the almost complete exclusion of the needs of the “ real sector”, resulting in the massive and unsustainable “financial sector-real sector imbalance” and the worst financial crisis and economic recession since the Great Depression! And, therefore, the Conference theme “Strategising India to be a $ 20 trillion Economy: Issues and Challenges In Accounting, Finance, Economics and Banking” provides the perfect backdrop, and contextual topicality, to the challenge of credible, effective, preemptive and proactive, as opposed to the reactive, regulation of the Indian derivatives markets in delivering on the public policy imperative of “financial sector-real sector balance” by doing the ‘Right’, and not, the ‘Easy’ thing, and which precisely is the central and key message of my today’s Keynote Address!
2. In India, we have a host of exchange-traded cash-settled derivatives contracts like currency futures and options, Government bond (Interest Rate) futures, index futures and options and single stock futures and options which all settle in cash rather than by physical delivery on their expiration. In contrast, in the US, these very same derivatives contracts, except index derivatives , are required to be settled by physical delivery on their expiration. And, the reason why derivatives must settle not in cash, but by physical delivery, on expiration of the contracts is that this discipline ensures almost real-time "organic connect", coupling, alignment and lockstep convergence between the derivatives price and the underlying cash market asset price much like the "organic connect" of the umbilical cord between the foetus and the mother until the physical delivery!
3 . Significantly, regardless of whether the derivatives are over-the-counter (OTC), or exchange-traded, the underlying theory and practice has been the so-called "law of one price" or, what is the same thing as, the "no-arbitrage argument", involving the replication of the derivatives cash flows in the underlying cash markets. In other words, a derivative of an underlying cash market asset which derives its value from that of the underlying cash market asset, will be so priced/valued that it is not possible to arbitrage between the cash market price and the derivative price because the derivative is correctly priced relative to the underlying asset in the cash market. For, if a derivative were priced expensive relative to the underlying asset in the cash market, an arbitrageur will engage in risk-free/risk-less arbitrage by selling the expensively priced derivative and simultaneously buying the asset in the cash market by financing it at the lower (than the repo rate implied by the expensively priced derivative contract) actual repo rate and physically delivering the asset on expiration and thus realising the targeted risk-free/risk-less arbitrage profit! In the opposite case, where the derivative is priced cheap relative to the underlying asset, an arbitrageur will engage in risk-free/risk-less arbitrage by shorting the asset in the cash market, investing the proceeds of short sale at the higher actual repo rate and buying the relatively cheap derivative (lower implied repo rate) and taking physical delivery of the asset on expiration of the contract , using the asset so acquired through physical delivery to return the asset borrowed for delivery into the short sale and, thus, again realising the targeted risk-free/risk-less arbitrage profit! This seamless and frictionless risk-free arbitrage, made possible by the discipline of physical settlement on expiration, will continue apace until, in equilibrium, the derivative was correctly priced/valued relative to the underlying asset in the cash market, "so much so that this very near perfect arbitrage-free pricing of derivatives itself will result in negligible actual physical delivery on expiration with the participants closing out their open derivatives positions with offsetting trades before expiration!" In a physically-settled derivative contract, the only open positions that go into actual delivery at expiration are only the arbitrage positions and not even those of hedgers who close out their positions just before expiration, achieving the objective of a true basis-risk-free hedge! The anecdotal evidence from the derivatives exchanges around the world is that in the physically-settled derivatives contracts, actual delivery is almost absent if not exactly zero! And it is precisely this feature of a physically-settled derivative contract of almost "no actual delivery" on expiration , due to the discipline of risk-free/risk-less cash-derivative arbitrage, that is the incontrovertible touchstone and hallmark of an efficient, deep and liquid derivatives market which fully delivers on its public policy purpose of real time efficient lockstep price discovery and basis-risk-free hedging in the underlying cash market assets! So, paradoxically, in the case of physically-settled derivatives, actual physical delivery on expiration "doesn't happen precisely because it can happen" were the prices of the derivatives and the underlying assets in the cash market to diverge, decouple, disconnect and not move in lockstep!
4. But in the case of the cash-settled derivatives contracts, because of the absence of risk-free/risk-less cash-derivatives arbitrage, and the leverage typical of the derivatives , there is considerable scope for a derivative to derive its price from itself, rather from its underlying asset in the cash market, and for speculators/manipulators to make derivative price go way too out of sync and lockstep alignment with that of the underlying asset, which, in turn, has the effect of making the derivative a "non-derivative", exposing, both arbitrageurs and hedgers, to not inconsiderable "basis-risk", and defeating, in the process, the very public policy purpose of a derivative acting as an effective true hedge for the “real sector”! It is noteworthy that ‘risk-free/risk-less’ cash-derivatives arbitrage in physically-settled derivatives becomes a ‘risky arbitrage’ in cash-settled derivatives because on the settlement day, arbitrageurs may either make a profit , or equally, a loss, because of the cash settlement price being different from the actual cash market price on the day of the settlement. This is so because on the cash settlement day, an arbitrageur ,who is short the cash market asset, may end up having to buy back his short position at a loss, or profit, or an arbitrageur, who is long the cash market, may end up having to sell his long position at a loss, or profit, except in the fortuitous event of the cash settlement price being exactly equal to the actual cash market price, in which case, of course, the targeted, but no way risk-less/ risk-free, arbitrage profit will be realised!
5. The foregoing cannot happen in the physical settlement version because, if a speculator manipulates the derivative price to be higher relative to that of the underlying, he will be punished by arbitrageurs who will buy the underlying asset cheap in the cash market and deliver it to the price manipulator at his higher price, making, as we have seen above, a risk free/risk-less arbitrage profit entirely at the expense of the manipulator! In the opposite case, risk-free/risk-less arbitrageurs will punish the manipulator by making him deliver an otherwise expensive asset at a lower derivatives price, again, as we have seen above, earning the targeted risk-free/risk-less arbitrage profit entirely at the expense of the manipulator! Thus, in cash-settled derivatives, both arbitrageurs and, therefore, hedgers, lose out to manipulators/speculators due to ‘basis risk’ but, in a sharp contrast, in physically-settled derivatives, arbitrageurs actually profit at the expense of price manipulators/speculators through ‘risk-free/risk-less arbitrage until the ‘basis risk’ to hedgers is completely eliminated, thus, sub-serving the public policy purpose of providing the true and effective hedge to the ‘real sector’!
6. While the underlying assets in the case of the single stock futures/options and currency futures/options are homogeneous, this is not the case with Government bonds underlying the Interest Rate Futures (IRF) . This is because a standard 10 year Government bond futures contract will cover a deliverable basket of comparable maturity bonds with widely differing coupons. They are made comparable through what is known as conversion factor which is unique to each deliverable bond. To arrive at the conversion factors of the individual deliverable bonds, they are all priced to give the yield of the notional/ hypothetical par bond underlying the IRF. These prices are then divided by the par price to give the respective conversion factors.
7. It will be instructive to review the evolution of the physically-settled IRF since its launch in August 2009. After their second launch in August 2009, the Interest Rate Futures on 10-year notional government bond had seen two settlements, viz., the December 2009 contract and March 2010 contract. Significantly, both traded volumes and Open Interest (OI), witnessed decline over the two settlements, eventually decaying very quickly to zero permanently. In particular, the December 2009 contract, which had a peak Open Interest of ₹ 980 million declined to a pre-settlement Open Interest of ₹ 610 million and settled “entirely” by physical delivery, representing physical settlement of 62% of the peak Open Interest! In contrast, the March 2010 contract, which witnessed a peak Open Interest of ₹ 570 million declined to a pre-settlement Open Interest of ₹ 420 million and also settled entirely by physical delivery, representing physical settlement of 74%! Both these settlements were a far cry from the hall-mark and touch-stone of an efficient, frictionless, seamlessly coupled, and organically connected, physically-settled futures market even where physical delivery typically does not exceed 1% of the peak Open Interest! In fact, on Chicago Mercantile Exchange and New York Mercantile Exchange, settlement by physical delivery is as low as 0.4% even though the contracts are physically settled types. This happened because of the inefficient ‘disconnect’ and ‘friction’ in the IRF market due to only one way arbitrage, viz., buying the cheapest-to-deliver (CTD), with the highest implied repo rate (IRR), by financing the same at the lower actual repo rate and simultaneously selling futures. In fact, for one market participant, who accounted for almost the entire ₹ 600 million worth of physical delivery into the December 2009 contract, the implied repo rate of the CTD was 6.75% as against the actual repo rate of 3.4%, representing a risk-less/risk-free arbitrage profit of 3.35%! But unlike this, on the other side, for the so-called benchmark, and most expensive-to-deliver, Government bond, the IRR was almost zero to negative, suggesting a risk-free arbitrage profit opportunity of short-selling this bond and investing the proceeds of short sale at much higher actual repo rate and buying the futures contract! "But, alas, this arbitrage could not be engaged in for want of short selling for a period co-terminus with that of the futures contract!" It is the possibility of this two-way arbitrage, working in the opposite directions, that, like a “good conductor” of ‘heat’ and ‘electricity’ in physics, will seamlessly conduct/transmit/permeate/impart liquidity and homogeneity, as it were, from the relatively more liquid (the most-expensive-to-deliver) benchmark government bond to the so-called illiquid (the cheapest-to-deliver) and heterogeneous bonds in the deliverable basket !
8. As we can easily see above, the physically-settled IRF failed not because of any design defect but because of the absence of the necessary and sufficient conditions for efficient, seamless and frictionless cash-derivatives arbitrage between the deliverable bonds and the futures contract. So, it might just as well be to list out the necessary and sufficient conditions for physically-settled IRF to succeed as indeed it has in all the developed and mature markets across the world. And the necessary and sufficient conditions are as under:
i) Symmetrical and uniform accounting treatment of both cash and derivatives markets.
ii) Removal of the ‘hedge effectiveness’ criterion of 80% to 125% which militates against the use of derivatives for hedging purposes for it is better to have ‘ineffective’ hedge than to have no hedge at all!
iii) Roll-back of the Held-to-Maturity (HTM) protection, that is, substituting the current “accounting hedge” with “derivative hedge”. This is because with HTM, there is no incentive/compulsion whatsoever for the use of market-based solutions like IRF which also require constant monitoring, infrastructure, transaction costs like brokerage and margins, etc.
iv) Delivery-based short-selling in the cash market for a term co-terminus with that of the futures contract and introduction of term repo, and reverse repo, markets, co-terminus again with the tenure of the futures contract for borrowing and lending of cash and G-Secs.
v ) Both for IRS (Interest Rate Swaps) and IRF, actual notional/nominal amount of IRS/IRF must be allowed on duration-weighted basis unlike the current regulation which restricts the maximum notional/nominal amount of hedging instrument to no more than the notional/principal amount of the exposure being hedged resulting in under-hedging of risk .
9. What should certainly not have been done was even to contemplate, much less permit, the most-liquid-single-bond IRF for the very simple reason that this benchmark security represents less than 20% of the current 10-year IRF deliverable basket and would, therefore, at a time, when we are talking about ‘inclusion’, this would amount to veritable ‘exclusion’ of 80% of the 10-year Government securities from the benefit of the liquidity of the most liquid benchmark 10 year bond which arguably is incompatible with the larger public policy purpose of IRF providing liquidity, depth and basis-risk-free hedge to as wide a universe of government securities as possible. But rather than establish and continuously ensure the above necessary and sufficient conditions on the ground for a successful physically-settled IRF , a cash-settled most-liquid-single-bond IRF was launched, instead, which would, to all intents and purposes, exist and trade as “an end in itself”, rather than serve “as a means” to the larger public policy purpose of real-time efficient lockstep price discovery, liquidity, depth and basis-risk free hedging in the stock of the heterogeneous government bonds.
10. In particular, the necessary condition for physically-settled derivatives in paragraph 8(iv) above holds just as much for all other derivatives such as those on foreign exchange, single stocks, indices and commodities and is , therefore, a ‘sine qua non’ for risk-free/risk-less cash-derivatives arbitrage as I have articulated in great detail.
11. In this background, it is indeed very heartening , and reassuring , to note that, in a first for the 25-year old Sebi, the Tyagi Sebi has very recently already made commodity derivatives mandatorily physically-settled and has also proposed physical settlement of equity derivatives noting that the trading turnover in these products has seen a sharp surge of over ten-fold over the past decade and the ratio of the trades in the equity derivatives to that of the equity cash market has risen to over 15-times. Curiously, reacting to the Sebi proposal, the Association of National Exchanges Members of India (ANMI), a pan-India body of trading members across the leading exchanges, including NSE and BSE, has submitted that "the NSE publishes options data by stating 'notional' turnover (as opposed to premium turnover), thus grossly overstating the total turnover in the futures and options segment". Specifically, it has argued that while the turnover in the equity derivatives is 15.59 times of that in the cash market, this ratio after taking only the premium value is only 2.53 times!
12. But these arguments of ANMI are specious and fallacious and do not hold water simply because what they are saying about the inflated volumes of the options because of counting notional value, as opposed to premium value, is not applicable to futures because the hedge ratio for futures is always either -1 or +1 and, therefore, both the cash market and the futures turnovers have to be exactly equal! Besides, significantly, in the case of the options, the notional value must necessarily be adjusted by the hedge ratio (delta) which varies between 0 and 1 for call options and -1 to 0 for put options. So, in the case of options with +1 and -1 delta, the options and the futures become identical where the notional value alone can, and must, be taken as is being done now. And, even if the delta is not 1, but, say 0.75, that is, 75%, the cash-market-equivalent delta-neutral options turnover will be equal to 75% of the notional amount and no way equal to the premium value, as contended by ANMI! So, in this framework, given that most active options positions will be at-the-money, in-the-money and deep-in-the-money, it will be reasonable to assume an overall delta/hedge ratio of 75% which will deflate the notional derivatives turnover to cash market turnover ratio from 15.59 to 15.59*0.75, that is, 11.70 times, which will still be 4.63 times the ANMI ratio of 2.53!
13. Contextually, I chaired a Working Group on Interest Rate Futures back in 2007, which very strongly recommended Physical Settlement! Besides, in several of my speeches and papers during the past decade, I have cogently articulated the public policy imperative of physical settlement of derivatives, with the key message that “the trouble with doing the “easy” (cash settlement), but not the “right” (Physical Settlement), thing is that undoing the “easy” (cash settlement) thing becomes a very “difficult” thing! I , therefore, take the present opportunity, what with the physical settlement of commodity derivatives behind it, to wish the Tyagi Sebi Godspeed in undoing the “easy” (cash settlement) thing and doing the “right” (physical settlement) thing not only in the equity but also in other exchange-traded derivatives like currency and interest rate derivatives in consultation with the Reserve Bank of India!
14. With these remarks, I conclude my keynote address and wish the Conference all the success that it so very much deserves!
