COMMENTS ON THE REPORT OF THE COMMITTEE ON DERIVATIVES
(December 26, 1997)
by
M.G.Damani
President
The Stock Exchange, Mumbai
 

First of all, I am not against the introduction of derivatives trading in the country.

I, however, have some reservations about time and pre-requisite before the introduction of derivatives in the country.

Section 1.1 (page 1) of the report says that the Committee was appointed in order "to develop appropriate regulatory framework for derivatives trading in India". The Committee has not finished the task assigned to it, hence, this is a report on partly completed task. The fact that Shri O.P.Gahrotra, Senior Executive Director, SEBI, has informed me that model exchange level regulations is being prepared, which should have been part of the report and deliberated in the Committee, corroborates that the task assigned to the Committee is incomplete. Section 7.2 (page 48) also mentions that the ‘Model Rules for Derivatives Exchanges being formulated, by the Committee separately’. My comments on the report of partly completed task are as follows.

The Committee’s terms of references has gained more importance in the light of the Asian financial and economic crisis. We must pay heed to numerous experts who are advising to re-examine our institutional framework and regulatory mechanism. Mr. Pieter Bottelier, Senior Economic Advisor, World Bank told a World Bank conference on the Asian financial crisis :

"We are now facing the consequences of a massive crisis that is the result as much of policy mistakes and perhaps institutional deficiencies in the Asian countries as it is the consequence of massive and sudden withdrawals of private investment capital, which is all legal and acceptable according to current established principles. The sudden withdrawal of capital can have social consequences that are perhaps as cruel as war, and in some senses even worse that war." (Time of India, February 4, 1998) I would also like to quote from Lord R.K.Bagri, Chairman, London Metal Exchange (LME), which illustrates the nature of derivative products. He managed the crisis at the LME when Sumitomo debacle came to light. Hence, from the viewpoint of a SRO his views are important to keep the fabric of market intact and to maintain investor confidence. He told the Indian Merchants Chamber, Mumbai on June 4th, 1997: "You have, today, some exceedingly bright people who are constantly trying to construct new ways of adding value to financial instruments, often by means of highly sophisticated methods. We use the term ‘derivatives’ for these instruments. The basic purpose of the instrument is a worthy one; namely to protect against risk. However, the value of derivative is based on a number of suppositions. There is a lot of subjective valuation and creativity in this field. An attempt to add value to something that is already arbitrarily valued can easily compound a mistake. If suppositions involved in valuation become unstuck the consequences can be quite hair-raising. So an instrument created to control risk can itself turn into a major risk." RECOMMENDATIONS DON’T PRESCRIBE BASIC REGULATORY FRAME WORK

The report has dealt with every other aspect of derivatives trading in general and index based futures in particular, but as far as the main task assigned to the Committee is concerned, precious little has been done. In fact, it has been left to SEBI/Stock Exchanges to develop regulatory framework.

In particular, the report has completely overlooked important areas such as :

(a) Entry and Eligibility, Rules, Regulations and Bye-Laws

The report by not prescribing criteria in details for margins, entry and eligibility, rules, regulations and bye-laws which includes rules governing market surveillance, risk management compliance, disciplinary actions, arbitration, code of conduct etc., which an exchange and clearing house should have, has put onerous duty on SEBI’s shoulders. This defeats the very purpose for which the Committee was setup.

The Report suggests that the margins should be separate for the derivatives and the cash segments. This would make arbitrage very expensive and use of capital inefficient - thereby, making the pricing of derivatives inefficient. The margining has to take into consideration both the derivatives and the cash segments within an exchange and computed on the basis of portfolio risk. Further, the committee doe not dwell at all upon the manner in which the margins should be collected. If more and more margins are going to be collected through bank guarantees it would increase the risk profile. The report does not say, in what manner can the clients pay margins ? It is important that types and amounts of margins; mode of computation; acceptable forms of collateral as margins with percentage of each type and haircuts should be specified in clear terms.

  1. Customer Protection
The report also does not talk about the responsibility of the regulator to assess the appropriateness of sales practices. The report fails to mention the use of audit trail to ensure that brokers do not disadvantage their customers in the trading process.

The report talks about an independent Investor Protection Fund for the Derivatives Division/Exchange which should be available to compensate clients in case a member defaults. If should specify further details for customer protection in case of defaults.

The derivatives committee’s recommendation that a derivative exchange should have arbitration and investor grievances redressal mechanism operative from at least four major metros should not be insisted upon. A derivative exchange which must be a strong SRO should decide for itself how it would like to service investors. Is there a regulatory agency anywhere in the world which has put such a partisan condition?

 
 

 
 
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