Derivatives in Emerging Markets

From 1995 onwards, a variety of developments have been taking place in India on the subject of derivatives markets. The pepper futures market of Cochin is set to go international in a few weeks, and the 1997 Union Budget announced policy measures towards more commodity futures markets. SEBI has constituted the L. C. Gupta Committee to formulate the regulations through which exchange--traded derivatives can commence in India. The focus of the work of this committee has been on equity index derivatives. The recently released report of the Tarapore Committee on Convertibility has recommended that exchange--traded derivatives should come about on the dollar--rupee and on treasury bills. These steps in policy--making are supported by NSE's efforts in this direction. NSE's developmental work towards exchange--traded derivatives began in 1995. This work was completed in middle 1996, from when on NSE has been awaiting clearance from SEBI which is needed to launch the derivatives market.

As we watch these efforts going into the creation of India's exchange--traded derivatives industry, comparisons with international experiences are inevitably useful. We know that in all OECD countries, derivatives are a crucial and vibrant part of the financial system. In addition, one interesting question has been ``what has the experience of other emerging markets been like''? Rudolf van der Bijl of the IFC has recently put together an interesting article titled Exchange--traded derivatives in emerging markets -- An overview which helps give us an overview of what is going on.

Consider the 23 significant exchanges in 16 emerging markets:

These countries have come to this level of development via a variety of different routes.

The most interesting and important experience is that of China, a fascinating case study of the merits and demerits of a relatively unregulated start of derivatives trading. In the early 1990s, a plethora of unregulated derivatives exchanges came up in China. Many of these exchanges lacked the key institution of the clearinghouse as counterparty, and most of them featured rampant market manipulation where insiders in the exchange management earned abnormal profits at the expense of outside market participants. In 1994, the 50 exchanges were consolidated into 15. In 1995, China's futures markets did a trading volume of around $1.2 trillion (for a comparison, India's equity markets do an annual trading volume of roughly $180 billion).

Many observers have cited China's experience with 50 exchanges as an example of how poorly--regulated and hasty growth of derivatives markets may be problematic. However, the other side of the picture is now clear: the experience with these 50 exchanges got the Chinese markets off the ground, and generated the necessary know-how amongst exchange staff, regulators and users. In the end, China has stolen a march ahead of us: it now has derivatives exchanges which have significant trading volumes on a world scale, while we have not yet begun.

One of the key motivations underlying futures markets in both Russia and China is quite important in India and other emerging markets. This is the weakness of commercial law both in precept and in practise. Under a weak legal environment, individuals and firms in the economy face problems in their contractual arrangements with each other. There are strong temptations to renege on a contract given the poor legal support for contract enforcement. In this situation, the futures clearinghouse is a vital institution which enables the functioning of the economy by supplying credit guarantees and producing contract performance. Indeed, the derivatives clearing corporation is often referred to as a credit guarantee corporation.

NSE's experience so far is a textbook example of this nature: the introduction of the clearing corporation (NSCC) has enabled a large--scale participation in the market by many individuals and firms which would otherwise have been thought uncreditworthy; this has enabled the growth of liquidity in the market and lowered entry barriers in the securities industry. If the legal system had been strong, then many of these firms could have fully participated in the economy even without the existence of NSCC.


     Impact of index derivatives upon the equity spot market

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                One Year Before                Two Years After
                Mkt.Cap.   Trad.Vol            Mkt.Cap.  Trad.Vol
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Argentina          3          1                  44        10
Brazil            43         21                  32        17
Spain            148         41                 155        62
Singapore         11          1                  24         4
Hong Kong         35         10                  74        23
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In countries where index derivatives markets have come about, what impact has it had upon the quality of the underlying equity market? Some evidence about this is summarised in the table above, which focusses upon the total market capitalisation of the country and the trading volume on the underlying cash market. Here we see significant gains in both market capitalisation and in trading volume on the cash market following the launch of trading in index derivatives. It should be noted that countries often venture into derivatives as part of a broader economic liberalisation process, hence the gains documented here are partly owing to this contemporaneous liberalisation process and not solely owing to the launch of equity derivatives. This data also serves to give us a sense of scale about the size and liquidity of the underlying market which are conducive to a launch of equity derivatives; India as of 1997 has a market capitalisation of $125 billion and an annual trading volume of $145 billion.

Consider the list of countries now working towards building derivatives markets:

An important case study is Mexico, which is in the same timezone as Chicago: the derivatives exchanges of Chicago have done a thorough job of launching numerous derivative products based on Mexican underlyings. This has made the creation of exchanges in Mexico much harder. Taiwan is another interesting case study. Taiwan is like India in the enormous delays which have beset the creation of a domestic derivatives exchange. In January 1997, markets in Chicago and Singapore started trading futures on a Taiwanese market index.

These episodes are reminders that the development of the derivatives area should be viewed in the global perspective and not just as an Indian question. Exchanges such as the Chicago Mercantile Exchange (CME), Chicago Board Of Trade (CBOT), Chicago Board Options Exchange (CBOE), American Stock Exchange, Sydney Futures Exchange, Hong Kong Futures Exchange and Singapore International Monetary Exchange (SIMEX) have all launched emerging market initiatives, whereby they aim to trade derivatives off underlyings from emerging markets. As far as Indian underlyings go, the main two objectives for these exchanges are a well-structured market index and the dollar--rupee exchange rate, based on which these exchanges would trade options and futures. Delays in the creation of exchange--traded derivatives in India are beneficial to them, and hinder the future potential of exchanges in India.

What are the problems which seem to bedevil the growth of derivatives markets across emerging markets in general? One source of difficulty is poor infrastructure, particularly in clearing and settlement. In India, two major initiatives in clearing for derivatives are National Securities Clearing Corporation (NSCC) which was created by NSE, and the First Commodities Clearing Corporation of India (FCCCI) which is being setup at the pepper futures market in Cochin.

National Securities Clearing Corporation (NSCC) was the first effort in clearing where the clearing corporation becomes the legal counterparty to both legs of every transaction, and thus eliminates counterparty risk. Until June 1996, NSCC was not doing this, and this vital infrastructure was lacking in the country, hence NSE's derivatives market could not have been launched. From June 1996 (i.e. a year ago) onwards, NSE's development effort was complete in having the NSE-50 index, a computerised trading mechanism, and a strong clearing mechanism.

The article by Bijl observes that ``jealousy or competition between securities, banking and derivatives sectors, and disputes as to who should supervise the market and under what rules'' has often been a problem. The experience of India, with the highly inaccurate comparison between derivatives and badla, is probably a variant of these conflicts. As far as the regulatory apparatus goes, things are simpler with equity derivatives, where SEBI is the only regulator. This is an area where we are likely to see derivatives markets come about in the country shortly.

Looking beyond equity, regulatory difficulties will arise. There is a considerable potential for conflicts between SEBI (which governs exchanges), RBI (which traditionally governs banking, the fixed--income market and the foreign exchange market) and the FMC (which regulates the commodity futures markets).

Derivatives is an area where a unified picture of the entire securities industry -- spanning equity, debt, foreign exchange, commodities and real estate -- is enormously useful. The functioning of the derivatives industry emphasises that a futures is a futures, regardless of the underlying on which the futures is being traded. The great derivatives exchanges of the world simultaneously trade derivatives on all of equity, debt, foreign exchange, commodities and real estate. In this sense, the basic policy issues faced in the derivatives area (market manipulation, strength of the clearinghouse and competition between exchanges worldwide) are universal to all five major markets. ``Turf wars'' inevitably lead to inferior development of financial markets.

The US is an example of a clumsy regulatory approach, where an agency named the CFTC regulates futures while the traditional securities markets regulator, the SEC, regulates options on securities. This artificial distinction has no economic rationale, and has served to distort the development of the markets. Similarly, while the focus of developing exchange--traded derivatives in India has been on futures on the equity index, the question of the RBI's regulatory approach looms large over the development of the derivatives exchanges, since interest--rate and currency futures are a crucial next steps in the development of the markets.

A clarification of some these issues is a major question in the agenda for policy--making in India's financial sector. Perhaps, this task rightfully falls upon the Finance Ministry, which would steer SEBI, RBI and FMC into an equilibrium conducive to the health of exchange--traded derivatives.

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