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Report of the Standing Council on international competitiveness of the Indian financial sector, Volume 1
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....eport of the Standing Council on international competitiveness of the Indian financial sector, Volume 1 <br>News and Press Release<br>Dated:- 10-9-2015<br><BR>============= Document 1 Report of the Standing Council on international competitiveness of the Indian financial sector, Volume 1 International Competitiveness of Currency, Equity and Commodity derivatives markets Department of Economic Affairs Ministry of Finance New Delhi Contents 1 Executive summary 2 Glossary 3 7 CONTENTS 3 Background 3.1 The Standing Council 3.2 The sub-committee 9 9 666 9 4 The approach adopted 4.1 Factors that shape financial sector competitiveness FER 11 11 15 4.2 Scope of this document. 5 Currency derivatives market 5.1 The market landscape 5.1.1 Competitors 5.2 Review of the factors of competitiveness Capital controls 5.2.1 5.2.2 Position limits 5.2.3 Tax policy 5.2.4 Frictions 5.2.5 Trading time 5.2.6 Margins 5.2.7 Regulatory risk 5.2.8 Vibrant domestic market 5.3 Summarising the factors: India vs. competitors 5.4 Impact on canonical users 5.5 A market report card for currency derivatives. 5.6 Policy proposals. 6 Equity derivatives market 6.1 The m....
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....arket landscape 6.2 6.1.1 Competitors Review of the factors of competitiveness 6.2.1 6.2.2 6.2.3 Capital controls Tax policy Frictions 6.2.4 Vibrant domestic market . 6.2.5 Regulatory risk 6.2.6 Position limits 6.2.7 Margins 6.2.8 Trading time . 6.3 Summarising the factors: India vs. competitors 6.4 Impact on canonical users 6.5 A market report card for equity derivatives 6.6 Policy proposals. 7 Commodity derivatives market 7.1 What makes commodity derivatives different Ministry of Finance FERR22222222222 2222285588232213 Department of Economic Affairs 1 7.2 The market landscape 7.2.1 38 Competitors. 7.3 Review of the factors of competitiveness 39 39 7.3.1 Capital controls 39 7.3.2 Vibrant domestic market . 40 7.3.3 Position limits 42 7.3.4 Regulatory risk 42 7.3.5 Frictions 44 7.3.6 Tax policy 45 7.3.7 Margins 46 7.3.8 Trading time . 46 7.4 Summarising the factors: India vs. competitor 7.5 Impact on canonical users 7.6 A market report card for commodity derivatives 7.7 Policy proposals. 8 Summary of policy recommendations 46 48 49 50 52 A A report card for the market for currency derivatives 56 B A report card ....
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....for the market for equity derivatives 57 C A report card for the market for commodity derivatives 59 D Regulatory guidelines for currency derivatives, Apr to Sep 2014 61 E Impact of restrictions on currency derivatives on market quality E.1 The regulatory actions under analysis 63 63 E.2 Measures of market quality used E.3 Findings 63 64 E.4 Conclusion 64 E.5 Graphs 65 CONTENTS Ministry of Finance Department of Economic Affairs 2 EXECUTIVE SUMMARY 1 Executive summary The international competitiveness of the Indian financial sector has come to the forefront because in recent years, an important subset of financial services in In- dia started trading globally. Unlike traditional areas of finance which remain non-tradeable (such as services at bank branches that interface directly with customers), there are others where overseas production is able to increasingly compete with Indian producers. This includes the two biggest financial markets of India: derivatives trading on the rupee and on Nifty. Global and domestic customers increasingly have the choice between a provider in India versus a provider abroad. The issue of international competitiveness o....
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....f Indian finance has long been a fo- cus of Indian policy thinking. This began with Percy Mistry Committee Report (2007) commissioned by the Ministry of Finance (henceforth, referred to as the MIFC report). This report emphasised the opportunity to provide financial ser- vices produced in India to a global audience, to make Mumbai one of the top five financial centres of the world. The report outlined the substantial rethinking that would be required of financial law and regulation, and improvements in urban governance, to enable this. The report pointed out that the additional benefit of such a focus includes the development of a more liquid domestic financial market, which in turn, would foster domestic financial development and higher GDP growth. The MIFC report has had a substantial influence in shaping downstream policy work. One such piece of work is the draft Indian Financial Code, which was re- leased by Financial Sector Legislative Reforms Commission (FSLRC) chaired by Justice Srikrishna, in March 2013. When the Indian Financial Code is enacted and fully enforced, financial law and regulation will largely be supportive for production and export of internati....
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....onal financial services from India. Since it will take some years for the Indian Financial Code to be enacted and enforced, a parallel strategy has been devised to improve Indian export of financial services using Finance SEZs (such as GIFT). This work connects integrally to questions of international competitiveness in the short run. At the time of the MIFC report, it was felt that the pace at which India would embark on exporting international financial services was going to be controlled by Indian policy makers. However, in recent years, there is evidence that this is not true, and that India may not have the flexibility on the pace of movement. There has been a sharp rise in overseas financial activities on Indian assets. The two most visible of these are the derivatives on the rupee and the market in- dex, Nifty. An active market for these has developed offshore. This report esti- mates on these two underlyings alone, trading outside India adds up to a daily turnover of just under USD 20 billion (out of the total market size of USD 63 billion). This means that the end-user has a choice of where to send an order to trade the rupee or Nifty. Rupee derivatives tra....
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....de in onshore Over-The-Counter (OTC) markets, onshore exchange-traded markets, offshore OTC markets, and offshore exchange-traded markets. Nifty trading is prohibited on onshore OTC markets but trade in the other three. The choice of offshore markets are available for Ministry of Finance Department of Economic Affairs 3 EXECUTIVE SUMMARY other areas also, such as credit default swaps on Indian assets, equity and debt issuance by Indian firms, hedging of commodity risk, where global venues are becoming increasingly important. One point of view regarding this loss of market share is that it ought not to be a cause for concern. There are two arguments behind this position. The first argument is that this loss of market share is not different from other instances of specialisation through trade. For example, India did not have a competitive advantage in computer hardware, the Indian computer hardware industry did not develop and this was the optimal outcome for India. The second argument is that, from an Indian point of view, it is prudent and sensible to ignore overseas activities and any loss of market share of financial services to offshore markets. This Committee....
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.... believes that there are five reasons for Indian policy makers to take corrective action to develop Indian finance so that it does not lose any further ground to offshore markets. First, financial services is a labour and technology intensive business. India is well-endowed on both these factors of production, which gives it a natural advantage in being globally competitive on producing financial services. India ought to be a dominant global player in this area, with markets that are strong enough to compete with global exchanges. This should be not just on Indian assets like (say) the rupee-dollar, but also on international assets like (say) the dollar-renminbi. Second, Indian markets have natural synergies between local information, local order flow and local liquidity for Indian underlyings. For this reason, domestic markets can develop as a natural market for Indian assets that overseas venues cannot match. Third, global competition will drive Indian exchanges, Indian financial firms and all aspects of Indian finance towards becoming more efficient in producing and delivering services. These productivity gains will feed back to all users of Indian finance, both....
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.... domestic and foreign. Fourth, when India fails to confront this competition and the Indian financial system diminishes in size and scope, it is the smaller firms that are adversely af- fected. So, while capital controls prevent Indian residents from trading on over- seas venues, there are many mechanisms through which Indian residents can use the overseas market when it delivers superior value. The largest Indian firms have become multinational and operate global treasuries, which allow them to increasingly run their operations without being constrained by capital controls. But this will not be true for the remaining firms that cannot access the overseas markets. For these firms, a well-functioning domestic financial system is essen- tial. If the domestic market cannot create liquidity and efficient prices within India for the rupee, the Nifty and securities issued by the top 100 firms, this will have adverse consequences for the smaller firms in India. Fifth, the MIFC report describes the necessity of a Bond-Currency-Derivatives nexus for a more effective monetary policy mechanism in India. If India is able to regain market share within the onshore market, and if t....
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....he Bond-Currency- Derivatives Nexus evolves locally, the central bank will become more effective with a strong monetary policy transmission that is able to help counteract busi- Ministry of Finance Department of Economic Affairs 4 EXECUTIVE SUMMARY ness cycle fluctuations. If, on the other hand, the onshore financial system re- duces, the central bank will find it more difficult to stabilise business cycle fluc- tuations. For these reasons, India must be concerned about the loss of market share of the onshore market. Once there is that clarity, there is the question of how to proceed to counteract the problem. For this, policy makers have to identify and tackle the source of the problem. This Committee has identified three broad sources of the problem: capital con- trols, mistakes in financial sector regulation and taxation. From the viewpoint of a global customer, sending an order to (say) the CME in the U.S. or the Singapore exchange (SGX) is frictionless. There are no capital con- trols. Domestic financial regulation at these venues is technically sound while being friendly to the goals of international competitiveness in financial services. Both have residen....
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....ce-based taxation where the activities of an overseas customer are not taxed. Both the CME and the SGX trade currency contracts on the rupee and on the Nifty. For India to compete in the new globalised world of finance, our markets must match these competitor markets in three respects: rationalise and ultimately remove capital controls, achieve technically sound financial reg- ulation, and shift to residence-based taxation. There are many elements under these three areas that can, and need to, be addressed. For example, a key irritant in rules on capital controls are the content of KYC requirements faced by overseas customers and the manner of their implementa- tion. India imposes onerous KYC rules and applies them with ambiguity, when a possible solution that makes us more internationally competitive is to match the requirements of the FATF as is done in other financial centres. Such ideas are proposed and worked out in considerable detail in this report. An important problem faced in India by financial firms, and their global cus- tomers, is the lack of certainty on rules and regulations. Sound financial reg- ulation involves low regulatory risk to market participa....
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....nts. Most jurisdictions that aim to be internationally competitive in financial services seek to provide regulatory certainty to all financial market participants, domestic and interna- tional. In India, there are concerns on these questions. For example, there is a real risk of a financial product or an activity being banned in India, or of mar- gins being sharply raised, or of position limits being sharply cut. When faced with such a risk, cautious financial sector participants will become reluctant to invest resources to build a business. Global and Indian firms are biased in favour of investing in building a business at cities with better regulations and reduced regulatory risk, such as London or Singapore, rather than build a business in India. If Indian finance is to become competitive on an international scale, a qualitative change is required where Indian financial sector regulators improve regulations and improve the regulation making process. SEBI has shown the way in this re- gard, with a track record where products are not banned and price fluctuations do not generate knee jerk responses aimed at reducing activity. This approach needs to spread all acros....
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....s the Indian financial system. Indian financial regulators are in the process of implementing the Handbook on adoption of governance enhanc- ing and non-legislative elements of the draft Indian Financial Code (Handbook, 2013), Ministry of Finance Department of Economic Affairs 5 10 EXECUTIVE SUMMARY which was released on 26 December 2013. This would help reduce regulatory risk. An international competitiveness perspective needs to be built into the Hand- book process. This Committee recommends that the Ministry of Finance, and financial sector regulators, should analyse every regulatory question from the viewpoint of global competitiveness to identify the areas in which we fall short. The best possible financial system for India is one which is able to compete with the world's best financial systems. Competing with the world has worked very well for the Indian economy in numerous areas, and finance is no exception. Measurement of our market performance compared to global markets is impor- tant, and financial sector regulators ought to make this a part of their regular reporting. This discussion has emphasised the rupee and Nifty, which are the largest mar- kets....
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.... in India today. However, there are several other areas where a greater in- ternational orientation would be beneficial. Some examples include agricultural commodity futures, an area where India has a natural advantage. Other ex- amples include Indian companies issuing foreign currency denominated bonds; Indian companies raising capital; global fund managers choosing to operate out of India. A useful point of comparison in this evaluation is China. China has launched a vigorous program for internationalisation of the renminbi and for easing capital controls to enable this. India should also consider such a strategy through which the Indian rupee becomes one of the important international currencies. Given the growth and size of the Indian economy, competing on the interna- tional landscape, first for domestic financial services and then for international financial services business is a key question that the financial sector policy mak- ers today have to face. On one hand, this is a question of reforming the domestic financial sector. But this perspective also motivates the concept of establishing specialised Finance SEZs or international financial service centers (I....
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....FSCs). IFSCs are enclaves where the difficulties of financial economic policy are solved using separate frameworks. Budget 2015 announced that Gujarat International finance Tec-city (GIFT) regulations would be notified by March, 2015. Such IFSCs may create a market that provides internationally competitive financial services, but only to foreign clients and participants within the IFSC. The benefits of this may not spill over to the Indian mainland. The work in this document can be useful towards understanding what reforms to financial regulation and taxation are required to make an IFSC succeed. But these reforms are even more desirable for the larger Indian system, as they will benefit all of Indian finance. Therefore, there ought to continue a parallel effort on the first best strategy for India: to build a modern financial system such as that proposed in the MIFC report, based on a sound legal framework such as that proposed in the Indian Financial Code. Ministry of Finance Department of Economic Affairs 6 2 Glossary AD Authorized dealer APMC ASX AUM Asset Under Management BEPS BIS BSE CBDT CDD CMIE CTT DCE DEA DGCX DoR ECA EUR Euro FATF A....
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....gricultural Produce Market Committee Australian Securities Exchange Base Erosion and Profit Shifting Bank of International Settlements Bombay Stock Exchange Central Board of Direct Taxes Customer due diligence Centre for Monitoring of Indian Economy Commodities transaction tax DaLian Commodity Exchange Department of Economic Affairs Dubai Gold and Commodities Exchange Department of Revenue Essential Commodities Act Financial Action Task Force FCRA Forward Contract Regulation Act FEMA Foreign Exchange Management Act F&O Futures and options FI Financial institution FII/FPI Foreign institutional/portfolio investor Foreign Investment Promotion Board FIPB FMC Forward Markets Commission FRG Finance Research Group FSLRC FSDC Financial Stability and Development Council Financial Sector Legislative Reforms Commission Food Safety and Standards Authority of India General Anti-Avoidance Rules FSSAI GAAR GBP GDR GMT GST ICE IGIDR INR IOSCO IRDA ISDA IST British pound Global depository receipt Greenwich mean time Goods and Services Tax Inter Continental Exchange Indira Gandhi Institute for Development Research Indian rupee International Orga....
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....nisation of Securities Commissions Insurance Regulatory and Development Authority International Swaps and Derivatives Association Indian standard time GLOSSARY Ministry of Finance Department of Economic Affairs 7 GLOSSARY JPY KYC LME London Metal Exchange MAT MF MoF MCX NCDEX NDF NRI NSCCL NSE NTSD NYMEX ODI OECD ΟΙ OTC PIO PFRDA PN QFI RBI SAT SCRA SEBI SGX Japanese yen Know Your customer Minimum Alternate Tax Mutual fund Ministry of Finance Multi Commodity Exchange National Commodity Derivatives Exchange Non-deliverable forwards Non-resident Indian National Securities Clearing Corporation Limited National Stock Exchange Non-transferable specific delivery New York Mercantile Exchange Offshore derivative instrument Organisation for Economic Cooperation and Development Open interest Over the counter Person of Indian Origin Pension Fund Regulatory and Development Authority Participatory note Qualified foreign investor Reserve Bank of India Securities Appellate Tribunal Securities Contract Regulation Act Securities and Exchange Board of India Singapore Exchange SHFE Shanghai Futures Exchange SPAN Standardized por....
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....tfolio analysis of risk STT TSD UBO UNCTAD ULIP USE USD VIX WDRA ZCE Securities transaction tax Transferable specific delivery Ultimate beneficiary owner United Nations Conference on Trade and Development Unit linked insurance plan United Stock Exchange United States dollar Volatility Index Warehousing Development and Regulatory Authority Zhengzhou Commodity Exchange Ministry of Finance Department of Economic Affairs 80 BACKGROUND 3 Background 3.1 The Standing Council A Standing Council of Experts was constituted in June 2013 in the Department of Economic Affairs, Ministry of Finance, to assess the international competitive- ness of the Indian financial sector. The Council comprises the following mem- bers: • Secretary, Department of Economic Affairs (Chairperson), • Chief Economic Adviser (Member and Alternate Chair), • Additional Secretary (Capital Markets, DEA) as Member Secretary, • Mr. Prithvi Haldea (Chairman, Prime Database), • Mr. Madhav Dhar (Board Member, GTI Group), • Mr. Shumeet Banerji (Ex-CEO Booz and Company), • Mr. Ravi Narain (Former MD & present Vice Chairman, NSE), • Mr. Vikram ....
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....Gandhi (CEO, VSG Capital Advisors), ⚫ Dr. Susan Thomas (Assistant Professor, IGIDR), • Mr. Leo Puri (MD, UTI -MF), • Ms. Arundhati Bhattacharya (Chairperson, SBI), • Mr. Thomas Mathew (Former CMD, LIC), and • A representative from CBDT, Department of Revenue. The mandate to assess the international competitiveness of the Indian financial sector gives the Council the following objectives: 1. Analysing the performance and completeness of the Indian financial markets in fully meeting client needs as per global standards; 2. Examining the various pecuniary and non-pecuniary costs in the Indian financial markets and comparing them with a competitor market; 3. Suggesting reform measures aimed at enhancing development, governance and transparency in these markets while ensuring that risks are contained and investor interests are protected; 4. Deliberating and advising on any other matter related to the above objectives. 3.2 The sub-committee In December, 2013, a sub-committee of the Standing Council was constituted with the following members: • Mr Ravi Narain, • Additional Secretary (Capital Markets), ⚫ Mr Prithvi Haldea, ....
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.... • Mr. Leo Puri, Dr. Susan Thomas, and • A representative from CBDT, Department of Revenue. Ministry of Finance Department of Economic Affairs 9 BACKGROUND The task of the sub-committee was to choose a set of areas to analyse for interna- tional competitiveness and to bring reasoned recommendations to the council. The analysis for the work areas was tasked to the Finance Research Group (FRG) at IGIDR, which has the responsibility of providing technical research-based in- puts to the work of the sub-committee. The sub-committee agreed on the follow- ing seven work areas in Indian finance for the FRG to take up for assessment in 2014: markets for currency derivatives, equity derivatives, commodity deriva- tives, equity issuance, equity trading, debt issuance and asset management. Ministry of Finance Department of Economic Affairs 10 THE APPROACH ADOPTED 4 The approach adopted The premise behind international competitiveness of the financial markets is to understand whether an individual or entity would choose domestic markets or their international competitor if they desired to take a position in Indian assets. If the onshore market is competitive i....
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....n comparison to the international market, then the investment would take place in the onshore market. Assessing this premise is a problem with a wide and complex scope. To deal with this complex- ity, the following strategy is used to evaluate the work areas under assessment: 4.1 1. Select specific sectors of the Indian financial industry with clear evidence that global markets are setting out to compete on Indian products and services. 2. To determine competitiveness, identify a relevant set of factors across which the Indian market place can be compared with competing global markets. These factors are identified based on (1) a literature review and (2) consulting the market participants. These are summarised in Box 1, and described in detail in Section 4.1. 3. The following work process has been used for each work area: (a) Identify key participants and institutions for consultations and discussions. (b) Identify the set of onshore markets and a set of competing offshore markets for a relative comparison. (c) Analyse how the onshore and offshore competing markets compare on each factor of international competitiveness. This is done through desk-based re- search,....
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.... data analysis and consulting market participants and experts. (d) Identify canonical users, from among domestic and foreign participants. Ex- amine the ease of access experienced and participation by these users to do- mestic markets and their global competitors. (e) Identify policy changes required to either reduce or eliminate restrictions in international competitiveness of onshore markets. (f) Create a market report card with key performance measures that can be used to track competitiveness between the onshore and offshore markets on an ongoing basis. The specific measures may differ from one work area to the next. For example, for the derivatives markets, the measures used are traded volumes and open interest (to capture the size of the market) and impact cost (to capture the cost of transactions). 4. The output of the above work process is then presented to the sub-committee on international competitiveness for their views and inputs. The work area report is finalised after taking these views into account. Factors that shape financial sector competitiveness The factors are features of the economic system that drive the economic decision making of domestic ....
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....and foreign participants while using financial services and products in India. These in turn drive the international competitiveness of the Indian financial system. Some of these factors are outcomes of national policy, some fall into the domain of regulations, and others are part of the microstruc- ture of a specific market. We identify eight factors as critical to international competitiveness of the Indian financial system, and use these as inputs within which to compare the Indian financial system with global competing counter- parts. These factors are: Ministry of Finance Department of Economic Affairs 11 THE APPROACH ADOPTED Capital controls Capital controls are rules of permission imposed by a country on use of its domestic markets. They are typically defined by law or regulation. International financial integration relies on free movement of capital across mar- kets. Integration with global markets can reduce cost of capital, support capi- tal deepening through high investments, improve diversification of investment risk, and help the development of domestic financial markets. Such integration implies either low or no restrictions on participation, except....
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.... for filters on unde- sirable/illegal transactions. However, it is also perceived as a source of macro- economic vulnerability, causing episodes such as capital surges and reversals caused by international rather than domestic factors. Capital controls is used to contain such risks, even though this comes at the cost of more expensive capital that adversely affects growth. This is particularly im- portant for emerging economies, where there are also high administrative costs for implementing these controls. These types of costs come in both pecuniary and non-pecuniary forms for participants, and create problems of governance. India has initiated the liberalisation of controls on capital. However, a detailed examination of different sectors of the financial system suggests that the legal and administrative framework involved remains intact, and ensures that the state and regulators can re-impose controls at will. Capital controls are assessed to be the highest ranking factor inhibiting the interna- tional competitiveness of the Indian financial system. There are several and varied restrictions on the access of foreign capital into the Indian financial system in each ....
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....of the work areas chosen. There are also restrictions on domestic access into com- petitor markets offshore. The analysis of capital controls presented in this report are typically a combination of controls on both inward access (foreign capital into India) and outward access (domestic capital outside India). Tax policy Imposition of taxes on transactions and taxes on participants in a market, adds to the transactions cost of participation in a financial system. The effect of this is similar to that of capital controls. The choice of how to tax financial activity in a country is driven by the type of financial system that the country aspires to have. There are two broad approaches to taxation of foreign participants: residence-based taxation where the global income of residents are taxed while non-residents are exempted, or source-based taxation where the domestic activities of non-residents are taxed. Countries that desire to have their financial system be a source of revenue are likely to choose residence- based taxation. An analogy can be derived from revenues from manufacturing in India. The reforms of the 1990s that liberalised the manufacturing sector had a fo....
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....cus on earning revenue from the exports of manufacturing goods. To facilitate the global competitiveness of manufacturing, India is moving towards residence- based taxation for manufacturing with zero-rating of Value Added Tax (VAT). A similar focus needs to be applied to creating a tax regime for financial services to improve the competitiveness of the Indian financial system. The MIFC report proposed that a tax regime for a globally competitive financial system should follow three principles: (1) a modern income tax and a low VAT throughout India – the report strongly advocated the introduction of GST as pro- posed in the FRBM Task Force report; (2) resident based taxation; and (3) removal of bad taxes - these were defined as those that incentivise evasion, raise costs more than yield, are discriminatory, are distortionary and cause friction while produc- ing goods and services (for example, stamp duties on capital assets, specifically in financial transactions). Ministry of Finance Department of Economic Affairs 12 THE APPROACH ADOPTED However, Indian tax policies remain a persistently inhibitory factor in international competitiveness of Indian finance,....
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.... inconsistent with these principles. There is no GST in place as yet. India applies source-based taxation on financial transactions by foreign investors. There are incidences of transaction taxes and stamp duty. Each tax regime has different rates across different segments of the market. Last but not the least, complex income tax rules apply to both domestic and foreign participants, and these rules can change unpredictably. A live example of this is the issue appli- cability of Minimum Alternate Tax (MAT) on FPIs that arose in December 2014. FPIs contended that since they had no permanent establishment in India and were not required to maintain books of accounts, they were exempt from MAT because MAT was only applicable on book profits. When the Authority of Advance Rulings (AAR) in 2012, ruled unfavourably for the FPIs/FIIS, the tax department issued no- tices to FPIs and foreign private equity (PE) funds for payment of MAT for previous assessment years. Now the Finance Act, 2015, provides MAT exemption of capital gains subject to STT, but only prospectively from April, 2016. Further, the specific provision of MAT exemption to just FPIs and, as a corollary, permit t....
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....he tax de- partment to impose MAT on other foreign entities, who may currently be earning exempt income (either under domestic law or due to treaty benefits). Even though an appeal in this regard is pending in the Supreme Court, and the Government has constituted a committee under Justice A. P. Shah to assess the issues pertaining to applicability of MAT for FPIs and other foreign investors, these foreign investors face uncertainty and litigation costs on how the prior period notices will be treated. Such uncertainty is a large deterrant for any long term FPI investment because the magnitude of the resultant cost can render a business model unviable. Regulatory risk The legal and regulatory framework of a country is an intrinsic feature of financial products and contracts (Chapter 8 of the MIFC report). The lack of certainty about the frequency and magnitude of changes in rules and regulation becomes an im- portant factor in differentiating similar products across different jurisdictions. Reg- ulatory risk has emerged as a critical factor diminishing the ability of the Indian financial markets and participants from competing against global alternatives. For example,....
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.... the non-deliverable forward (NDF) contract on USD-INR which is traded in offshore OTC markets, is comparable to a USD-INR forward contract in the onshore Indian market. However, the latter poses greater uncertainty risk to the global participant because of frequent changes in domestic regulations and procedures. Regulatory risk adversely affects the ability of both foreign and domestic partic- ipants to take medium- and long-term decisions to build businesses. Regulatory uncertainty also has a pecuniary impact in the form of compliance costs. Finally, given the fragmented nature of financial sector regulation in India, there is a differ- ent form and level of regulatory uncertainty in different sectors of Indian finance. Thus, foreign participants find offshore markets that offer products on Indian assets an attractive alternative to Indian markets because these markets offer higher reg- ulatory certainty. This holds true even for domestic participants that are permitted access to global markets. Frictions Frictions arise from rules of procedure on participation. These are indirect factors that impact market access for participants, and are distinct from capital co....
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....ntrols because they apply only to participants who are permitted access. Frictions can vary widely across sectors. An example of frictions is documentation that is required in order to undertake transactions in currency derivatives markets in India. The nature and type of docu- Ministry of Finance Department of Economic Affairs 13 THE APPROACH ADOPTED mentation to trade currency derivatives in Indian markets effectively inhibit partic- ipants who are permitted to trade these contracts. There are rules on cancellation and re-booking of transactions that inhibit their flexibility in managing currency risk in real-time. Another example of frictions is the difference in rules of participation for foreign and domestic participations in the case of the equity derivatives markets. Restric- tions on margin collateral are higher for foreign investors than for domestic in- vestors. Frictions also appear to arise from fragmentation of the regulatory framework in India. There is little understanding among different financial regulators about how the other segments are regulated, or how they link together. Further, there is a lack of trust and co-ordination among the regulat....
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....ors, which hamper the development of common rules of access across market segments. In contrast, global markets present a more coherent and unified set of rules, both within and across markets, that encourage participation. The lack of a vibrant domestic market The state of development of the domestic financial market and the presence of so- phisticated domestic participants form an important factor in determining com- petitiveness. A vibrant domestic market offers diverse, independent and localised trading views, from a wide participant base that act as counterparties. Such a mar- ket offers depth and liquidity that is persistent and volatility that is understood. Indian financial markets have a unique structure of participation. There is very lim- ited participation by the fund management institutions, such as banks, insurance firms, mutual funds and pension funds, that are a large source of capital in global market places. The lack of participation of these institutions is partly due to reg- ulatory restrictions and lack of regulatory coordination. In part, it is also a conse- quence of the incentive structure created by the ownership pattern and governance mecha....
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....nisms of these institutions and the uncertainty in the regulatory regime that inhibits the development of business. Consequently, this results in a weak domestic ecosystem in Indian financial sector. Market microstructure Lastly, there is a gap that differentiate the domestic and global financial markets that are based on issues of market microstructure. They are: • Position limits Position limits are limits placed on the maximum number and size of trans- actions that can be undertaken. All across the world, position limits are set when markets are developing and these are generally set as a fraction of the market at any given point in time. They form a part of the risk management system at exchanges and seek to control concentration risk. However, posi- tion limits, if so designed, can also have an impact similar to that of capital controls in limiting access. • Trading time Trading time is the defined time period for which markets are open. • Margins Margins are imposed by exchanges to eliminate counter party risk. For ticipants, these are transaction costs that need to be paid to use the markets. These microstructure factors either act as bar....
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....riers to access (such as position limits and trading times) or as a transaction cost (such as margins). par- A summary of the eight factors that impact international competitiveness is pre- sented in Box 1. Ministry of Finance Department of Economic Affairs 14 THE APPROACH ADOPTED Box 1. Summary: Factors that shape global competition 1. Capital controls: These are the rules of permission to access markets and are typically defined by regulation or law. They determine the extent and variety of participation in a market. 2. Tax policy: These involve rules around imposition of taxes on transactions and/or participants in a market. Taxes add to the cost of transactions or the cost of participation, and their effects are similar to those of capital controls. 3. Regulatory risk: This arises due to lack of certainty about the rules of participation. It impacts the ability of participants to take medium- and long-term decisions regarding participation. 4. Frictions: These are indirect factors or rules of procedure that impact market access for partici- pants. 5. Vibrant domestic market: This refers to the state of domestic financial development in a mar- ket and the pre....
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....sence of sophisticated participants. A liquid domestic market can attract wider participation with greater ease. 6. Position limits: These are limits placed on the maximum number and size of transactions per- mitted in a market. They are used as measures of risk containment in the exchange traded segment. They are similar to capital controls in their impact. 7. Trading time: This defines whether markets are open whenever there is trading interest. 8. Margins: These are imposed by exchanges to eliminate counter party risk. They add to transac- tion costs for participants. 4.2 Scope of this document This document contains reports on the following three sectors on international competitiveness: (1) Currency derivatives, (2) Equity derivatives, and (3) Com- modity derivatives. Each sector report has the following sections: 1. The market landscape • Products and services in the chosen sector • Key offshore competitor markets • Features and size of the onshore and the offshore market 2. Analysis of the factors of competition • A comparison of how the onshore and offshore markets fare on the eight- factor framework • The impact of the eight....
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.... factors on some canonical users • A quantitative market report card (MRC) comparing key metrics across the onshore and offshore markets. Some examples of these metrics are the fol- lowing: Ministry of Finance Department of Economic Affairs 15 THE APPROACH ADOPTED - Size of market: typically measured as daily average traded volume in USD billion. For derivatives markets, the open interest outstanding (mea- sured in USD billion) captures the amount of capital invested in the mar- ket and is also a measure of the market size. Cost of trading in the market: measured by impact cost for a fixed trans- action size. 3. Policy proposals The policy proposals for improving international competitiveness of the Indian fi- nancial sector follow the eight-factor framework and are categorised into three sets: (1) Proposals on economic decisions at the level of the central government. For example, limitations on capital account convertibility or policy on source-based taxation. (2) Proposals with reference to administrative aspects of implementation of key economic decisions. For example, documentation and compliance require- ments, lack of clarity on tax administration....
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.... or uncertainty in regulation. (3) Propos- als on market microstructure-linked issues. For example, design of position limits and margins or market trading time. In order to implement these proposals, a host of reforms need to be undertaken. This report identifies these reforms, along with the agencies in whose jurisdiction the implementation of the reform falls. The report also categorises the reforms in terms of the speed with which they can be implemented as: • Short-term measures: low hanging fruit which can be implemented within the next six months. • Medium-term measures: those that need to be evaluated first, and hence may get implemented within the next one to two years • Long-term measures: which need a significant reversal of the existing policy and I may require a longer time frame for implementation. Ministry of Finance Department of Economic Affairs 16 Table 1 The size of the INR-USD derivatives market CURRENCY DERIVATIVES MARKET In USD billion April 2013 October-December 2014 Exchange OTC Total Exchange OTC Total Onshore Offshore 10.6 20.9 31.5 2.5 17.9 20.4 1.4 17.6 19.0 1.3 17.6 18.9 Total 12.0 38.5 50.5 ....
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....3.8 35.5 39.3 Source: OTC offshore and onshore, BIS April 2013; Exchanges onshore and offshore from NSE, MCX, USE, DGCX. 5 Currency derivatives market 5.1 The market landscape There are four possible venues where an interested counterparty can take a po- sition on INR-linked derivatives: 1. Onshore OTC: Under FEMA, banks who are Category I Authorised dealers (AD Category I) are the only counterparties recognised by the RBI in an OTC derivatives trade. 2. Offshore OTC: Commonly known as the Non-Deliverable Forwards (NDF) market. There are several NDF centres globally, with London and Singapore estimated to be among the largest. 3. Onshore Exchange: Futures and options (F&O) on USD, GBP and JPY that pair with the INR as one leg of the product, currently trading on the BSE, MCX, NSE and USE. 4. Offshore Exchange: Exchanges that typically trade futures on the USD-INR and include CME, DGCX, ICE and SGX. Out of the various currencies available for trade against the INR, the market for the USD-INR is the largest, with approximately 89-90% of total trading volume. In 2013, the average daily turnover of the INR-USD derivatives market, both onshore and offshore, was US....
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....D 50.5 billion.¹ The contribution of the onshore, offshore and the exchange and OTC segments is given in Table 1. The same table shows the average daily turnover of these four markets for the quarter of October to December 2014. The data are updated for all markets except for the offshore OTC market, for which the only source of data is the BIS triennial survey of April 2013. This comparison shows that the overall INR-USD derivatives market dropped by 22% in this period. The sharpest drop is seen in the size of the onshore exchange traded market which decreased by 76%.² 1The INR does trade against other currencies such as the EUR and the JPY. However, since the INR-USD trade is estimated to be around 89 to 90% of all INR trading, we focus on only this currency pair. 2The decrease in the traded volume on the exchange traded market happened immediately after the regulatory restrictions imposed by the RBI and SEBI on participation by banks, and the size of participation permitted in the form of position limits and initial margins imposed. Details about these interventions as well as other interventions restricting market access, along with the impact on the exchan....
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....ge traded currency derivatives markets are presented in Appendix E. Ministry of Finance Department of Economic Affairs 17 CURRENCY DERIVATIVES MARKET 5.1.1 Competitors Among global exchanges, DGCX is currently the main competitor for Indian exchanges. In February 2014, the daily traded volumes on DGCX was almost 50% of the traded volumes on all the Indian exchanges combined. London has a large NDF market, which is a key competitor to the Indian OTC market. Singapore competes with both its exchange and OTC market. There is active trading in the NDF, and SGX trades futures on USD-INR. Singapore is chosen as the primary competitor for the onshore INR derivatives markets. There is a strong link between the exchange and the OTC markets in supporting order flow and liquidity of products. As a global financial centre, Singapore focuses on providing a comprehensive range of financial services to participants - SGX announced the introduction of USD-INR futures in Novem- ber, 2013.3 Thus, while both DCGX and SGX are strong competitors for the off- shore order flow for INR derivatives, we expect that Singapore will likely emerge as the dominant competitor in this market. ....
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....5.2 Review of the factors of competitiveness 5.2.1 Capital controls Capital controls in the onshore INR derivatives market are high. In the OTC segment, they are defined and administered by the RBI, whereas in the exchange segment, they are jointly administered by the RBI and SEBI via the Standing Technical Committee. There are several constraints on participation by foreign and domestic investors in exchange traded currency derivatives. Prior to June 2014, foreign participants (including SEBI-registered FPIs and NRIs) were prohibited from trading on ex- changes. Banks were prohibited by RBI from taking proprietary positions in July 2013. From June 2014 onwards, FPIs have been permitted to participate and banks have been allowed to once again take proprietary positions, but with several restrictions (RBI Circular: June, 2014a). The June 2014 guidelines have also introduced several restrictions on participation by domestic entities (details provided in Appendix D). In the onshore OTC markets, only AD category I banks are allowed to be coun- terparties. The RBI exercises strict regulatory controls for permitted participants. FPIs registered with SEBI are allowed to h....
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....edge only to the extent of their expo- sure in Indian debt and equities. Domestic firms are allowed access to this mar- ket, but only for the purpose of hedging and subject to procedural constraints on exposure and contracts. For example, exporters can hedge exposures of up to 100% of the average export performance of the past three years. Importers, on the other hand, can do so only to the extent of 50% of their past import per- formance. Banks are allowed to take proprietary positions, but only for asset liability management, and to hedge capital and gold price risk. http://www.marketwatch.com/story/sgx-launches-asian-foreign-exchange-futures-2013-10-28 Ministry of Finance Department of Economic Affairs 18 CURRENCY DERIVATIVES MARKET In contrast, in the offshore markets, there are no restrictions on participation both on exchanges and OTC. There may, however, be requirements of mem- bership/documentation required for participation, especially on the exchange segment. 5.2.2 Position limits Indian exchanges introduced currency F&O in August, 2008 with the following position limits: • Client-level limits at the higher of 6% of OI or USD 10 million. •....
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.... Member-level limits for non-bank members at the higher of 15% of OI or USD 25 million. • Member level limits for banks at the higher of 15% of OI or USD 100 million. • These limits are combined across F&O positions. In March 2009, member-level limits were further increased for non-bank trading members to the higher of 15 percent OI or USD 50 million (SEBI Circular: March, 2009). But in July 2013, client-level position limits were changed to the lower of 6% of OI or USD 10 million and non-bank trading member position limits to the lower of 15% of OI or USD 50 million (SEBI Circular: July, 2013). These were effective decreases in the position limits of market participants. At the same time, banks were completely banned from taking proprietary positions (RBI Circular: July, 2013). These changes were made with no warning to the market and were justi- fied as a measure of currency defense to control a weakening INR. These led to a considerable shrinkage in the size of these markets (from daily average turnover of USD 5.76 billion in April-June, 2013 to USD 3.36 billion in July-September, 2013). In June 2014, SEBI allowed FPIs to trade in the exchange traded....
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.... segment for the first time. FPIs were permitted to take derivatives positions of up to a limit of USD10 million, subject to constraints. Position limits for domestic investors were reversed from "lower of" to "higher of" 6% OI or USD 10 million and that for non-bank members to "higher" of 15% OI or USD 100 million. Banks have again been permitted to participate, but subject to their net overnight open position limits (NOOPL). In the onshore OTC markets, the derivatives position taken by participants are linked to their underlying exposure to foreign currency through trade or invest- ments, which needs to be demonstrated using documentation. There are also restrictions on the type of products that different categories of participants can use and on the modification of contracts once they are entered into. In contrast, offshore markets have more accomodating or no position limits. On offshore exchanges, position limits are much larger than those permitted on on- shore exchanges. At the DGCX, client- and member-level position limits are USD 160 million and USD 400 million, respectively. At the client level, it is USD 330 million at the SGX and USD 2 billion at the CME....
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..... There are no position limits in the offshore OTC market. Ministry of Finance Department of Economic Affairs 19 CURRENCY DERIVATIVES MARKET 5.2.3 Tax policy There are no transaction taxes in either the Indian or global exchange traded currency derivatives markets. However, a stamp duty of 0.002% of the turnover value is applied on Indian exchanges. Competitor markets for currency derivatives, such as Dubai and Singapore, fol- low a residence-based taxation regime. While India follows a source-based di- rect taxation regime, we do have de-facto residence-based taxation treaties with Mauritius and Singapore. In addition, there are challenges on the treatment of currency F&O transactions from an income tax perspective. In India, the levy of STT is used to determine the applicable rate of capital gains tax, with transactions charged to STT attracting a lower rate of capital gains tax. In addition, exchange transactions on which STT is paid are deemed to be non-speculative and can avail greater tax set-offs. Since STT is not levied on the entire currency F&O segment, these transactions: (1) may be liable to a higher rate of capital gains tax; and (2) may be deemed a....
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....s speculative for the purpose of availing tax set-off. 5.2.4 Frictions Participants in offshore markets trade in Indian currency derivatives as they would any financial product in their portfolio. These products are either offered through the exchange platform with a central counterparty or in the OTC seg- ment by financial firms that evaluate and take on the counterparty credit risk. The procedures in both these markets are harmonized, giving participants the ability to seamlessly access both segments based on their requirements. In ad- dition, rules and procedures are also harmonized across products, enabling par- ticipants to take a holistic view of the returns on their investment. For example, participants can invest in the Nifty futures and options on SGX and hedge cur- rency exposure that arises out of this transaction using the USD-INR futures on SGX or on the NDF market. In contrast, currency derivatives trades in Indian markets are subject to very different rules governing transactions in the OTC market. Participants trading forwards in the Indian OTC markets are required to provide supporting docu- mentation for each transaction. This requirement for docu....
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....mentation is onerous. All participants - whether foreign or domestic are required to demonstrate underlying exposure to foreign exchange risk. Additional documentation is re- quired when contracts are modified to match changes in exposure to the cur- rency. Thus, if a counterparty faces a need to reduce or increase the amount of currency hedging, they have to "cancel-and-rebook" their currency forwards contracts. Since these positions can change frequently either because of business flows or changes in the currency itself, the documentation at every position and for every change can be extensive. Regulatory guidelines on modifying positions have also been changed frequently in the past and are a source of uncertainty. In the June 2014 guidelines, the requirement to provide documentary evidence to support a position taken has been extended even to the exchange segment. Another friction in the OTC market is the KYC and compliance requirements. Ministry of Finance Department of Economic Affairs 20 20 CURRENCY DERIVATIVES MARKET Table 2 Comparison of exchange trading times across venues Trading Venue Trading Hours 09:00 17:00 IST (GMT+5.5) 07:00-23:30 (GMT+4) Ind....
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....ia Dubai Singapore CME 07:30 19:35 ST ICE (US) 17:00 - 16:00(T+1) CT 18:00 - 17:00(T+1) EST Duration (hours) 8.0 16.5 12.0 23.0 23.0 KYC norms for foreign participants have been eased recently by SEBI under the new FPI regime. However, compliance requirements for entities taking deriva- tives exposure and intermediaries acting as counterparties continue to be oner- ous. Entities are required to provide regular certification that their derivatives exposure across exchange and OTC markets is not greater than their underlying currency exposure, and intermediaries need to monitor and confirm the same. In contrast, offshore exchanges and OTC markets have KYC norms that only re- quire customer due-diligence norms. Compliance requirements in offshore mar- kets are only with respect to ISDA guidelines and contract terms. 5.2.5 Trading time Table 2 compares the trading times across the various trading venues. It shows that domestic markets for currency derivatives offer the shortest time span com- pared to trading times for Indian currency in offshore competitor jurisdictions. Indian exchanges offer the least amount of time for investors to participate. The same ....
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....holds true for onshore OTC, which operates from 9 a.m. to 5 p.m. IST. In contrast, the offshore OTC market is open round the clock for trading INR derivatives. Additionally, the overlap of trading time with other important offshore desti- nations for trading the Indian rupee is also small. This means that after Indian markets close, price discovery for INR shifts to locations such as Dubai and Sin- gapore. 5.2.6 Margins There are three types of margins imposed by exchanges in the onshore market: ◠Initial margin, specified as a percentage of value of open positions. These need to be adjusted upward for the risk of T+2 settlement. • Calendar spread margin, specified as different fixed values for different horizontal spreads. • Extreme loss or exposure margins. Initial margins were increased from 1% to 2% by SEBI in July 2013 (SEBI Circular: July, 2013). When adjusted for overnight settlement risk and loaded with the calendar spread and extreme loss margins, the total margin requirement, for the near month contracts, on onshore exchanges is 5% of the positions taken. 4Margins were increased to reduce trading on INR derivatives and aimed to curb exc....
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....essive volatility of the exchange rate. Ministry of Finance Department of Economic Affairs 21 CURRENCY DERIVATIVES MARKET In comparison, offshore exchanges have an initial margin and a maintenance margin specified as a fixed USD value for a contract. As a percentage of con- tract size, the total margin requirement is 3% on SGX. Margins on offshore ex- changes remain stable and are changed transparently according to a rule book, with changes intimated to market participants in a timely manner. In the OTC markets, counterparties undertake transactions taking into account counterparty credit risk. Thus, there are no explicit margins paid, and the trans- action costs include the price of counterparty credit risk. 5.2.7 Regulatory risk The previous factors refer to the frequent and significant changes in regulations and guidelines that have taken place both in the exchange and OTC currency derivatives segments onshore. This indicates that there is a high degree of regu- latory risk involved in trading in the onshore markets. Some examples of regula- tory interventions in the last three years are given below. The most significant of these was during the recent episode....
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.... of sharp currency depreciation in July 2013, when both RBI and SEBI intervened in the currency derivatives market. • In December 2011, RBI withdrew the freedom to cancel and re-book forwards con- tracts for FIIS (RBI Circular: December, 2011). They also reduced the past perfor- mance linked exposure limits available to domestic firms by 25%. In addition, ADs were prohibited from cancelling and re-booking for their clients. • In May 2012, the intra-day open positions of the ADs were fixed at five times the NOOPL available to them (RBI Circular: May, 2012a). The NOOPL of the banks on the positions involving INR as one of the currencies would not include the positions in exchange traded products (RBI Circular: May, 2012b). Thus, F&O positions on the exchanges could not be netted against forwards positions, reducing the extent of participation by banks in the F&O markets. • In July 2012, the RBI reversed regulations on cancellation and re-booking of for- ward contracts for only residents and exporters. • In July 2013, the RBI prohibited ADs from undertaking proprietary F&O positions. Simultaneously, SEBI reduced the position limits for clients an....
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....d trading members and doubled the margin requirements. These unanticipated regulatory changes led to an adverse impact on the ex- change traded currency derivatives segment. Tayal (2013) finds that in the pe- riod after the July 2013 interventions, liquidity, in the form of traded volume and open interest, dropped significantly. At the same time, volatility of the exchange rate increased and the USD-INR spot rate depreciated. Thus, the regulatory in- terventions of July 2013 achieved neither the stated objectives of stabilising the drop in the currency nor curbing the increase in volatility. However, the competitive position of the onshore market for currency risk man- agement worsened. The evidence shows that the adverse effect on the interna- tional competitiveness of the onshore exchange markets, both in terms of size and liquidity, has remained since then. In June, 2014 there have been several changes made by RBI and SEBI in regula- tory guidelines for both the exchange and the OTC markets. These new guide- lines have removed most of the restrictions introduced in July 2013. However, Ministry of Finance Department of Economic Affairs 22 CURRENCY DERIVATIVES M....
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....ARKET a stringent new set of restrictions have been introduced, in the form of addi- tional documentation requirements, to take exposure on exchanges. This has neutralised the benefits of removing the July 2013 restrictions. A summary of these changes is given in Appendix D. 5.2.8 Vibrant domestic market Participation on the onshore exchanges is hindered by small position limits, fric- tions and regulatory uncertainty. Thus, participants with large exposure require- ments prefer the OTC market over exchanges. The onshore OTC market is dom- inated by a small number of banks as ADs which form one leg of the trade in all transactions that take place in this segment.5 Thus, access to this market tends to depend upon the banking relationships that clients have with the ADs. Indian residents, individual or entities, have no access to the offshore markets for INR derivatives. They have no avenues for managing currency exposure that they are not able to hedge onshore. This applies to implicit risks that arise due to trade price parity where domestic trade is exposed to international price fluctuations. It also applies to explicit risks that remain unhedged due to various c....
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....onstraints on participation that both the exchange and OTC markets onshore impose. 5.3 Summarising the factors: India vs. competitors Box 2 summarises how the eight factors affect the international competitiveness of the Indian currency derivatives markets, using a comparison between trades on the NSE versus SGX. The comparison ranks the eight factors in their order of importance for the international competitiveness of this market. 5Section 45V(1) of the RBI Act, 1934 defines the validity of a derivative transaction as: Notwithstanding anything contained in the Securities Contracts (Regulation) Act, 1956 (42 of 1956) or any other law for the time being in force, transactions in such derivatives, as may be specified by the Bank from time to time, shall be valid, if at least one of the parties to the transaction is the Bank, a scheduled bank, or such other agency falling under the regulatory purview of the Bank under the Act, the Banking Regulation Act, 1949 (10 of 1949), the Foreign Exchange Management Act, 1999 (42 of 1999), or any other Act or instrument having the force of law, as may be specified by the Bank from time to time. Ministry of Finance Department of Ec....
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....onomic Affairs 23 Box 2. Analysis and prioritisation of the eight factors Factor 1. Capital controls 2. Position limits 3. Tax policy 4. Regulatory risk 5. Frictions 6. Trading time 7. Margin 8. Vibrant domestic market SGX None Larger, not a constraint Residence-based CURRENCY DERIVATIVES MARKET NSE Banned Small, constraint Residence-based from Absent Low 0740-1930 (GMT+7) Mauritius and Singapore, source-based otherwise High Worse (10 hours) Low Strong 0900-1700 (GMT+5.5) (8 hours) High Weak 5.4 Impact on canonical users The risk of currency fluctuations for domestic firms goes beyond just the direct exposure that comes from engaging in exports and imports. The potential loss to Indian firms because of a depreciation in the USD-INR rate varies across firms, primarily due to the extent to which their production process is exposed to im- port price parity. For example, a domestic firm engaged in the manufacturing of goods that uses petroleum products as raw materials procured from a domestic firm is exposed to currency price risk due to changes in price of its raw mate- rial on account of exchange rate fluctuations. This risk can only be he....
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....dged to a limited extent onshore in the exchange segment. Based on such a perspective, Aggarwal et al. (2014) analyse the exposure that listed Indian domestic firms have to face due to changes in the currency. They do this by asking how much the market capitalisation of these firms changes when the currency depreciates. Their sample comprised 1,700 of the largest listed firms in March 2013. They find that the market capitalisation could drop by more than Rs.1.6 trillion in a week due to an extreme movement in the currency. This is equivalent to a 3.75% loss in the total market capitalisation of Rs. 43 trillion. This report identifies four categories of canonical users who need to hedge risk using currency derivatives. The first three categories are domestic non-financial firms that have exposure to foreign exchange risk, either through revenue, ex- pense or loans. The domestic non-financial firms are categorized into small, medium and large firms based on their total assets in March, 2013.7 The fourth category comprises FII investors in Indian debt and equities. 6The extreme movement is a depreciation in the USD-INR rate that has a 1% probability of occur- rence. 7....
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....Firms are defined as small, medium and large based on total assets in their 2012-13 balance sheet. Small firms have total assets less than Rs. 5 billion, medium firms between Rs. 1 billion and Rs. 5 billion and large firms greater than Rs. 5 billion. By these definitions, there are 820 small, 740 medium and 951 large firms in the Prowess database of CMIE. Ministry of Finance Department of Economic Affairs 24 CURRENCY DERIVATIVES MARKET How the eight factors impact the use of the currency derivatives markets by these canonical users is listed in Box 3. In each case, there are several bottlenecks faced by any user in accessing currency derivatives in order to take currency exposure. Box 3. The eight factors mapped to four users Factor Small firm Medium firm Large firm 1. Capital controls No access to offshore markets No access to offshore markets No access to offshore markets 2. Tax policy Source based, tax even on gains on hedges 3. Regulatory risk Present 4. Frictions 5. Vibrant domes- tic market Low importance Exchange access not an issue. OTC access based in firms' relation- ship with banks. 6. Position limits Not a constraint Source based, ....
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....no clar- ity on whether gains from exchange transac- tions are speculative Present Onerous documen- tation requirements to demonstrate forex exposure Exchange access not an issue, but lack of liq- uidity on exchanges a constraint. OTC access limited by size of bank- ing relationship Constraint Source based, no clar- ity on whether gains from exchange transac- tions are speculative High Onerous documenta- tion requirements to demonstrate exposure Lack of liquidity on exchanges, espe- cially options, a sever constraint. Lack of products in OTC, no options Severe constraint FPI Not permitted on onshore exchanges till June 2014. Lim- ited access to onshore OTC. No constraints on access to offshore exchange and OTC Source based, con- straint High Onerous KYC, compli- ance and documenta- tion requirements Constraints of custo- dian as intermediary on onshore OTC. No constraint on offshore OTC 7. Trading time 8. Margins Low importance Challenge to manage liquidity for margin calls Constraint Initial margin not a constraint. Challenge to manage liquidity for margin calls Severe constraint Constraint on onshore OTC. Large limits....
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.... on offshore exchanges and no limit on offshore OTC Low importance Severe constraint Low importance Ministry of Finance Department of Economic Affairs 25 Table 3 The report card for currency derivatives Size of Participation CURRENCY DERIVATIVES MARKET Traded Volumes¹ (USD Billion) Open Interest² (USD Billion) Cost Impact Cost³ (%) Q4-14 Q1-15 Q4-14 Q1-15 Q4-14 Q1-15 Exchanges India 2.45 2.87 4.62 4.47 0.105 0.099 Intl. 1.31 1.51 1.99 2.01 OTC India 17.93 16.14 Intl. Q4-14 denotes October-December, 2014; Q1-15 denotes January-March, 2015. 1 Traded volumes for India are summed across NSE, BSE and MCX-SX. BSE data are available only from Q1 2014. Only DGCX data are used for international traded volumes. Traded vol- umes in onshore OTC markets are calculated using outright forwards and swaps data from the RBI weekly statistical supplement. 2Open interest is calculated using daily bhavcopy data from NSE, BSE and MCX-SX. BSE data available only from Q1 2014. DGCX daily bhavcopy data have been used for international markets. 3 Impact costs are reported for a transaction of USD 1 million, from snapshots of the NSE limit order b....
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....ook. 5.5 A market report card for currency derivatives The market report card for currency derivatives for the recent period is given in Table 3. The detailed market report card for currency derivatives is presented in Appendix A. The position of the Indian market vis-a-vis international competitors for USD- INR derivatives trading shows the following: • The onshore exchange markets were competitive on the size of markets – both in terms of traded volumes and open interest – from April 2013 to June 2013. They became significantly less competitive after the July 2013 regulatory measures, with onshore size dropping and offshore size growing (Appendix A). • The onshore OTC markets are significantly larger than the exchange. However, anecdotal evidence from conversations with market participants suggests that the offshore OTC (NDF) markets are large and liquid. The size of the offshore OTC market from the BIS (2013) triennial survey results shown in Table 1 reflects this. The size of this market cannot be tracked regularly since these are mostly bilateral deals with limited disclosures. • Transaction costs of trading are lowest for onsh....
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....ore OTC trades. These are significantly higher on the onshore exchanges but only marginally higher on the offshore OTC (NDF) markets, suggesting that the offshore NDF markets are fairly liquid. 5.6 Policy proposals The following are important reforms that need to be undertaken to create a glob- ally competitive market for INR derivatives, categorised under short-term ac- tions and medium-term and long-term goals. Against each proposed action or goal, the agencies in whose jurisdiction the implementation falls are listed in parentheses. Each of these reforms requires immediate effort so that each of the goals are met over their respective horizons. Ministry of Finance Department of Economic Affairs 26 CURRENCY DERIVATIVES MARKET 1. Short-term actions (a) Clarifications are required on ambiguities in direct tax treatment of exchange transactions for domestic firms. (CBDT, DEA) (b) Regulatory uncertainty about the Singapore and Mauritius tax treaties should be removed. (CBDT, DEA) (c) KYC and compliance requirements should be brought in line with CDD re- quirements under FATF. (SEBI) (d) Documentation for demonstrating underlying foreign exchange exposure should ....
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.... be removed. (RBI) (e) Restrictions on cancelling and re-booking OTC contracts should be removed. (RBI) (f) Restrictions on domestic institutions participating in exchanges should be re- moved. (RBI, SEBI, IRDA) (g) There should be no ban on market participation. Any regulatory intervention should be carried out and implemented using Handbook (2013) procedures. (DEA, RBI, SEBI) (h) Decisions about trading times should be devolved to exchanges and ADs. (SEBI, RBI) (i) Product innovation should be left to exchanges. For example, exchanges should select what currency pairs to trade, and what products to trade on these pairs, and not regulators. (SEBI) 2. Medium-term goals (a) Tax treaties similar to the Mauritius and Singapore treaty should be signed with all other FATF-compliant countries. (DEA) (b) The non-legislative recommendations of the FSLRC should be implemented by all financial sector regulators, as laid out in the Handbook (2013). This will ensure greater clarity on the regulation making process to all participants and reduce regulatory risk. (DEA, RBI, SEBI) (c) An expert committee must be set up to rationalize position limits and mar- gins, and design ....
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....a framework that places the choice of the exact limits and margins with the exchanges. (DEA, SEBI) 3. Long-term goals (a) India must move to a residence-based taxation regime over the longer term. (DEA, CBDT) (b) The Ministry of Finance must prepare a time-bound plan for the internation- alisation of the INR, just as the Chinese government has prepared a plan for the internationalisation of the Renminbi. (DEA) Ministry of Finance Department of Economic Affairs 27 EQUITY DERIVATIVES MARKET Table 4 Equity derivatives market size, March 2013 Values in USD billion OTC Exchange Open interest Average daily traded volumes Open interest Average daily traded volumes Onshore 22.1 21.6 0 0 Offshore 6.9 0.6 22.8 Total 29.0 22.2 22.8 Source: SEBI; Exchanges onshore and offshore includes index derivatives on NSE, BSE and SGX Source: OTC offshore includes PNs issued on equity and derivatives 6 Equity derivatives market 6.1 The market landscape Indian equity derivatives trade on three venues: 1. Onshore Exchanges: In India, equity derivatives can only be traded on exchanges. OTC contracts are not permitted under the provisions of the SCRA. There are two ....
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.... sets of products: • Derivatives on equity indices - F&O on the NSE-Nifty and the BSE-Sensex index. These also trade on offshore exchanges. • Derivatives on single stocks – these trade only on the onshore market. The international competitiveness of Indian equity derivatives are evaluated based only on the performance of the index derivatives markets. These account for most of the traded volume (85% of the total traded volumes in FY 2014) in the equity derivatives markets. 2. Offshore exchanges: Nifty F&O trades on SGX, Osaka exchange and CME. BSE- Sensex futures trade on DGCX. 3. Offshore OTC: Participatory Notes (PNs) and Offshore Derivative Instruments (ODIS) issued by SEBI-registered FPIs against onshore equities and equity derivatives. PNs are also issued against SGX Nifty F&O.⹠Table 4 summarises the size of these markets as of March 2013. The size of the market in terms of daily traded volumes is readily available for the exchanges. OTC transactions are typically not centrally reported. In the case of PNs and ODIS issued by FPIs, transactions are reported to SEBI. These transactions are used to estimate the size of the notional outsta....
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....nding derivative positions taken by foreign participants in Indian equity. 6.1.1 Competitors Among global exchanges, SGX is the main competitor for Nifty index deriva- tives. In 2013, the open interest (OI) of Nifty futures at SGX was almost twice 8Section 18 of SCRA. "Globally, the OTC markets for equity derivatives flourish in parallel with the exchange traded markets. For example, the notional amount outstanding in the exchange market in June 2013 was USD 7.7 trillion and that in the OTC market was USD 6.8 trillion. Ministry of Finance Department of Economic Affairs 28 EQUITY DERIVATIVES MARKET that at NSE. Nifty futures also started trading on CME and Osaka from 2010 and 2014, respectively. While BSE-Sensex F&O are traded onshore at BSE and offshore at DGCX, the traded volume of these products is much lower in com- parison to Nifty F&O traded at NSE and SGX (Appendix B). OTC markets in equity derivatives are not permitted onshore. Trading in the offshore OTC markets takes place through PNs and ODI. These are issued by SEBI-registered foreign investors against their investments in onshore equities and derivatives and are subscribed to by those foreign partici....
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....pants who wish to take exposure to the Indian markets without going through the formal registra- tion procedure prescribed by SEBI. Offshore, PNs and ODIs are also issued in Singapore, against Nifty F&O traded on SGX. 6.2 Review of the factors of competitiveness 6.2.1 Capital controls Foreign participation in the Indian equity derivatives markets is hampered by two elements of capital controls, (1) limitations on access and (2) fragmented markets. Limitations on access Foreign investment in equity derivatives was categorized by participant type into (a) Registered foreign participants and (b) Unregistered foreign entities. The first category included FIIs, their sub-accounts, NRIs, QFIs and foreign intermediaries registered in India. Of these FIIs, sub-accounts and NRIs were permitted to par- ticipate in exchange traded equity derivatives. QFIs and foreign intermediaries were not permitted. All participants in the unregistered category did not have di- rect access to the market but could participate by subscribing to PNS/ODIs, which could be issued by registered FIIs as per SEBI guidelines. In June 2014, the FII/sub- account regime was replaced by the new FPI regi....
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....me. All existing FIIs/sub-accounts and QFIs are required to re-register as one of the three categories of FPIs defined under this regime. NRIs and PIOs are not permit- ted to register as FPIs and can participate in the onshore market only through the portfolio investment scheme. ODI/PN issuers and subscribers face stricter norms. Category III FPIs are not permitted to issue ODIs/PNs, while broad-based hedge funds, even those with a regulated investment advisor, cannot issue or subscribe to PNs. The new FPI regime has re-adjusted the boundaries of capital controls, and ratio- nalised the categories and requirements of registration. 10 It has not removed con- straints on participation. In contrast, there are no limitations on access on offshore exchanges and in the offshore PN/ODI market. For example, all participants can trade in Nifty F&O on SGX through registered intermediaries. Similarly, all partic- ipants can subscribe to PNs on Nifty F&O on SGX. 10 Finance Act, 2015 has amended Section 6 of the Foreign Exchange Management Act (FEMA), to provide that control on capital flows as equity will be exercised by the Government, in consul- tation with the RBI. This impl....
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....ies that the Central Government will be the decision making body for controls on capital account transactions in all equity securities, including equity issuance, equity trading, equity derivatives, depository receipts (DRS) on equity underlying, flows under the Liber- alised Remittance Scheme. In addition, there is also a Budget, 2015 proposal to merge the Foreign Portfolio Investment (FPI) Scheme with the Foreign Direct Investment (FDI) Scheme. This, when implemented, along with the FEMA Section 6 amendment will lead to a single approval window for foreign investment in domestic equity markets. Ministry of Finance Department of Economic Affairs 29 EQUITY DERIVATIVES MARKET Fragmented markets Since the interest of foreign participants in Indian equities lies in the dollar returns they can earn on their investment, participants should be able to seamlessly and simultaneously access equity and currency markets, both for taking positions as well as to leverage and hedge. However, implementing a position on a hedged dollar return investment involves trading in separate markets in India. The costs and frictions of doing this are compounded by different rules of access ....
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....and types of constraints on foreign participants in each of these markets. There are limitations on the size of positions permitted in exchange traded equity and currency deriva- tives as well as on the issuance and subscription of PNs. There are also both size limits and participation frictions for positions taken in OTC currency derivatives. This fragmentation ensures that India's international competitiveness will be low in comparison with international competitors that provide a one-stop shop for all these requirements, with little or no procedural limitations. For example, SGX has a both a liquid Nifty F&O and a USD-INR F&O market. There is also a PN market on SGX Nifty F&O and a NDF market on INR derivatives. SGX allows trading on equity spot through GDRs. Any attempt to compete with this mar- ket would require that Indian markets develop an equity market equivalent to the Bond-Currency-Derivatives (BCD) nexus as described in the MIFC report. 6.2.2 Tax policy The following tax issues affect Indian equity derivatives: 1. Lack of tax clarity for foreign participants under the proposed GAAR 2. Taxation of PNs 3. STT 4. Applicability of stamp duty The proposed ....
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....GAAR, which is targeted for implementation starting April 2016, offers insufficient guidance on availing treaty benefits even for existing cate- gories of FIIS.11 Even though there have been clarifications by DEA that indirect transfer rules would not be extended to tax PNs through tax-friendly jurisdic- tions, recent media reports to the contrary create uncertainty. 12 Both STT and stamp duty are applicable to this segment and add to the cost of transactions. For example, STT is payable on all sell transactions on F&O. It is 0.01% of the traded price of futures and 0.017% on options premiums. A 0.125 % STT is payable on the settlement price by the buyer of an option that is exercised. Even though equity derivatives are cash settled and there is no transfer of the underlying securities, a stamp duty is imposed on them. Stamp duty at 0.002% is applicable on the notional amount of options expiring in-the-money and on selling futures. 11 Budget 2015 announced the proposal to postpone the applicability of GAAR by two years. GAAR would apply prospectively to investments made on or after 01.04.2017. The deferment only creates a temporary relief and the issue of tax on fore....
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....ign investors under the GAAR and BEPS regime needs to be dealt with comprehensively before the new implementation deadline. 12 Participatory note holders may be taxed in the next budget: Parthasarathi Shome, The Economic Times, 7th April, 2014 Ministry of Finance Department of Economic Affairs 30 EQUITY DERIVATIVES MARKET 6.2.3 Frictions For equity derivatives, frictions take the form of variations in rules across differ- ent categories of participants, going against the principle of providing a "level playing field" for all market participants. The following are examples. • Foreign participants are constrained to post only cash in INR, sovereign securities and certain AA-rated corporate securities as margin collateral, whereas domestic participants are additionally allowed to post equity securities and units of liquid mutual funds (MFs) as margin collateral. Foreign participants were not allowed to hedge the cash INR collateral till June 2014. In June 2014, they were permitted to trade on exchange traded currency derivatives segments and can now hedge exposures up to USD 10 million without demonstrating any underlying exposure. This limit can be used by t....
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....hem to hedge their collateral requirements on the equity derivatives segment. â— Foreign participants do not receive any interest on their margin collateral, whereas domestic participants receive interest. Both FIIs and domestic MFs face constraints on taking positions. They cannot go short in excess of their stock holdings or go long in excess of their cash holdings, sovereign securities and other permitted securities. There are onerous KYC norms for foreign participants who are registered with SEBI. FIIs permitted to issue PNs are required to disclose the ultimate beneficiary owners of PNS/ODIs issued by them to SEBI every month on a proactive basis. This requirement of proactive disclosure is in contrast to the FATF agreement, where such disclosures are sought only on demand. In comparison, rules of procedure for offshore markets are the same for all cate- gories of participants. 6.2.4 Vibrant domestic market Currently, the Indian equity derivatives market suffers from both constraints on participation and product innovation. Domestic financial institutions (FIs) are either not permitted or do not participate in the equity derivatives market. The following....
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.... are examples. • IRDA has given in-principle approval to insurance companies to trade equity deriva- tives but has not provided operational clarity. As a consequence, insurance firms have no positions in equity derivatives, even though Unit Linked Insurance Prod- ucts (ULIPs) are a significant part of their portfolio. • Domestic and foreign banks are not permitted to participate by the RBI. • Foreign intermediaries in India are not permitted to participate, under FIPB norms. • Equity mutual funds show low participation in equity derivatives. For example, as of March 2014, the asset under management of equity MFs was USD 34 billion, and only 0.9% of this was in all derivatives. The regulatory approval process for new products is slow, and only a few pro- posed product innovations make it to market. Nifty futures were introduced in 2000 and Nifty options in 2001. The next new product was implied volatil- ity derivatives on VIX, which was introduced in 2014. It took four years to the Ministry of Finance Department of Economic Affairs 31 EQUITY DERIVATIVES MARKET market launch of VIX derivatives from when they were proposed. 13 6.2.5 Regulator....
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....y risk There have been several instances of regulatory actions in the markets, some of them abrupt and stringent, which have led to high regulatory uncertainty for participants. In response, there has been a significant shift in trading focus to offshore markets. For example, a ban on PNs in 2007 resulted in a shift in vol- umes to offshore markets, particularly SGX. Another source of regulatory risk in India is regulatory over-lap and lack of regulatory consistency across different market regulators. One such instance was the RBI shutdown of futures on the INR-settled, USD-denominated Nifty index. These contracts were introduced in December 2008 but discontinued in July 2009. The lack of regulatory consistency does not always span multiple regulators. An example of this is the regulatory mandate on mutual funds to use equity derivatives. Both mutual funds and eq- uity derivatives are regulated by SEBI. Yet the feedback from market participants has consistently been that there is lack of regulatory encouragement on the use of equity derivatives by the mutual funds. 6.2.6 Position limits Low position limits constrain participation, especially that of large institutio....
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....nal players. Position limits in equity derivatives are the higher of USD 83 million or 15% of market OI for futures and options separately. This implies a limit of USD 300 million for index futures and index options each. In comparison, po- sition limits on SGX are USD 345 million on the buy side and the sell side each. While current position limits on NSE are comparable with SGX, stronger partici- pation from domestic institutions and greater investments by domestic financial firms would make the market more robust. For one thing, larger domestic mar- kets would manifest in higher level of OI, which in turn, would lead to higher position limits. 6.2.7 Margins As with all derivatives exchanges globally, both NSE and SGX have SPAN-based margins. However, effective margins on NSE include the initial margin and ex- treme loss margin adjusted for the T+2 settlement risk. In comparison, offshore exchanges have an initial margin and a maintenance margin that are specified as a fixed USD value for a contract. As a percentage of contract size, the total margin is 10% on the NSE, whereas it is approximately 3.3% on the SGX. Higher margins on the NSE imply higher transaction....
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.... costs that makes it less competitive than exchanges such as the SGX. Part of the reason that the margins in India are high is that they were designed to compensate for higher uncertainty on overall payment systems as well as to reduce counterparty risk. There is a need to re-assess margins required for higher levels of efficiency in the rest of 13 Derivatives trading on NSE volatility index gets nod, Business Standard, Jan 20, 2014 Ministry of Finance Department of Economic Affairs 32 EQUITY DERIVATIVES MARKET Table 5 Comparison of trading time across trading venues Trading Venue Trading Hours 09:00 15:30 IST (GMT+5.5) Duration (hours) India 6.5 Dubai 07:00-23:30 (GMT+4) 16.5 Singapore 09:00 18:15 (T) ST 16.0 19:15 02:00 (T+1) ST CME 17:00 16:15 CT 22.1 (Trading halt 20:30 - 21:30) the payments and settlement systems in India today compared to 1998, when the equity clearing corporations first became operational. 6.2.8 Trading time The trading time for equity derivatives in India is shorter than that for offshore competitor jurisdictions (Table 5). 6.3 Summarising the factors: India vs. competitors Using a comparison of the levels of trades on NSE ....
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....and SGX, Box 4 summarises the eight factors of international competitiveness for equity derivatives. It high- lights the challenges in achieving international competitiveness and also pro- vides a ranking of the eight factors in their order of importance for this market. Box 4. Analysis and prioritisation of the eight factors Factor 1. Capital controls 2. Position limits 3. Tax policy 4. Trading time 5. Margin NSE High Constraint a. STT applicable b. Stamp Duty c. Source based 0900-1700 (GMT+5.5) SGX None Not a constraint a. No STT b. None c. Residence based 0740-1930 (GMT+7) (10 hours) Approximately 3.3% Low (8 hours) 10% 6. Frictions High 7. Regulatory risk Present Absent 8. Vibrant Weak Strong domestic market 6.4 Impact on canonical users How the eight factors affect the competitiveness of the onshore market for equity derivatives are analysed based on how they impact the participation of canonical users of these products. The two user categories identified for this market are (1) SEBI-registered foreign investors – FPIs – and (2) all other foreign investors. This Ministry of Finance - Department of Economic Affairs ....
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....33 EQUITY DERIVATIVES MARKET comparison is presented in Box 5. Box 5. The eight factors mapped to two users Factor 1. Capital controls 2. Tax policy 3. Frictions. 4. A vibrant domes- tic market 5. Regulatory Risk 6. Position limits 7. Margins 8. Trading Time Registered FPIs Onerous registration/compliance requirements. Varied rules of par- ticipation. Segmented market ac- cess. No clarity on applicability of GAAR and Indirect Transfer Rules. STT and stamp duty applicable. Limitations on collateral. Onerous compliance requirements for PNs. Limited market development. On- shore OTC not permitted. Uncertainty on account of inter- regulator interactions. Regulatory stance on PNs keeps changing. It is a constraint. Higher margins on onshore ex- changes. It is a constraint. Other foreign investors No direct access to onshore mar- kets. Access only through PNs. No clarity on taxation of PNs. For PNs, FATF CDD compliance not sufficient. Proactive disclosure of beneficiary holders rather than on demand. No access to the domestic market. Regulatory stance on PNs keeps changing. It is a constraint. Not applicable. May be a constraint. 6.5 A marke....
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....t report card for equity derivatives The market report card for the equity derivatives market is presented separately for equity F&O. The main findings from the report card are as follows: . For futures: - Indian exchanges have much higher traded volumes. Traded volumes on the competitor exchanges are nearly half of those onshore. - - The OI on the offshore exchanges is higher. On the SGX, it is approximately twice that on the Indian exchanges. - Liquidity is higher on Indian exchanges (as measured by impact cost of a Rs.1 million transaction). • For options: Indian exchanges have higher traded volumes and OI compared to competi- tor exchanges. In comparison to Indian currency derivatives, the market report card for equity derivatives shows that India has a better position on being internationally com- petitive in equity derivatives. At the same time, it shows that competitor markets such SGX have a share of the futures market, which it has continued to retain over the last few years. The report card for the most recent period is in Table 6. The detailed market report card is presented in Appendix B. Ministry of Finance Department of Economic Affairs ....
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....34 Table 6 The report card for equity index derivatives EQUITY DERIVATIVES MARKET Size of Participation Traded Volumes¹ Open Interest² (USD Billion) (USD Billion) Cost Impact Cost³ (%) Q4-14 Q1-15 Q4-14 Q1-15 Q4-14 Q1-15 Futures India 2.61 2.08 4.40 4.92 0.004 0.005 Intl. 0.95 0.36 9.78 7.95 0.018 0.014 Options India 62.04 36.28 22.33 22.38 0.429 0.506 Intl. 0.002 0.006 0.25 0.27 PNs 33.57 39.11 Q4-14 denotes October-December, 2014; Q1-15 denotes January-March, 2015. Traded volumes for India are summed across Sensex on BSE and Nifty on NSE for India and only Nifty on SGX for Intl. 2Open interest is calculated using daily NSE bhav copy data, daily BSE bhav copy data, and Thomson Reuters trades for SGX. 3 Impact costs are for a transaction of Rs.1 million for Nifty futures and for at-the-money Nifty options, using market-by-price data from NSE and Thomson-Reuters quotes for SGX. 6.6 Policy proposals Indian equity derivatives markets are in a relatively better position on interna- tional competitiveness than (say) the currency derivatives markets. However, the analysis reveals several areas where policy changes can imp....
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....rove competi- tiveness of the Indian markets. The following is a list of suggested reforms, organised according to the eight factors. The reforms are classified into short, medium and long term, based on the nature of the reforms and the time that may be required to implement them. The agency in whose jurisdiction the reforms fall are listed in parentheses. 1. Short-term actions (a) Implement FATF CDD requirements for a non-resident to trade on equity derivatives. This will reduce their registration and compliance burden. (SEBI, DEA) (b) Make exchange traded index derivatives accessible to all foreign participants that meet the FATF CDD requirements. (SEBI, RBI) (c) Eliminate the regulatory uncertainty about treaty benefits under the proposed GAAR. (DEA, CBDT) (d) STT and stamp duty add to transactions costs. STT should be removed. Stamp duty should not be applicable to cash settled products such as index deriva- tives, as there is no delivery of the underling taking place. (SEBI, DEA, CBDT) (e) Trading and clearing rules must be nationality-neutral and participant-neutral. (SEBI, RBI) • Expand the list of permissible securities as collateral. (SEBI) â....
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....¢ Allow FIIs access to currency derivatives on exchange (already imple- mented by RBI in June 2014). (RBI) (f) Rationalise the regulatory position on PNs. (SEBI) (g) Move towards FATF-compliant CDD disclosure for Participatory Notes. (SEBI) Ministry of Finance Department of Economic Affairs 35 55 EQUITY DERIVATIVES MARKET (h) Indian exchanges should time market opening to overlap with SGX. (SEBI) 2. Medium-term goals (a) Create a working group for common clearing among exchange traded prod- ucts: equity, equity derivatives and currency derivatives. (SEBI, RBI) â— Phase I: As applicable within a single exchange, across multiple seg- ments. • Phase II: Across exchanges, with competing clearing corporations. (b) Implement Handbook (2013) processes for governance of the regulation mak- ing process at SEBI. This should be followed for product approval, margin setting, position limits etc. (SEBI, DEA) (c) Remove regulatory restrictions on domestic FIs. (SEBI, RBI, IRDA) (d) Create an expert committee to rationalise position limits and margins. (SEBI, RBI) This committee will: • Rationalise position limits across all market segments. • Crea....
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....te a single margin system across market segments in two phases. • Rationalise margins vis-a-vis competitor markets like SGX. (e) Devolve decisions about margins, position limits, trading time, and product innovation, to exchanges with suitable monitoring by SEBI. This will provide operational flexibility to the exchanges and enable them to strive for compet- itiveness. (SEBI) 3. Long-term goals (a) Move to a residence-based taxation regime over the longer term. (DEA, CBDT) (b) Set up an expert committee for creating an onshore OTC market for equity derivatives. Amend SCRA suitably for this to take place. (DEA, SEBI) Ministry of Finance Department of Economic Affairs 96 36 COMMODITY DERIVATIVES MARKET 7 Commodity derivatives market 7.1 What makes commodity derivatives different Unlike the financial derivatives contracts, commodity derivatives have an addi- tional complexity because the underlying tends to be associated with a physical good. This distinction often causes any debate on commodity derivatives to be intertwined with issues related to the spot market for the underlying commodi- ties. Though the competitiveness of the derivatives market is linked....
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.... to the spot market, it is not contingent on it. A study by UNCTAD (2009) shows that a well- functioning commodity futures market not only improves price discovery and risk management but also sets the context for spot market reforms. Therefore, when analysing commodity derivatives, it is useful to understand the issues about the underlying commodities as distinct from issues about deriva- tives. An instructive framework takes three categories of factors (listed with examples) into account: 1. Derivatives market specific factors Contract design and trading and settlement systems. 2. Spot market factors that impact delivery of derivatives contracts Logistics and warehousing infrastructure as well as quality and variety of grades on the underlying commodity. Laws 3. Factors directly effecting the spot and indirectly effecting derivatives prices and interventions that affect the quantity of a commodity available for trade. Both 1. and 2. are used to analyse the international competitiveness of the Indian commodity derivatives markets. The first step in the analysis is to identify a target set of commodities. The space of commodity derivatives covers agricultural (re....
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....ferred to as agri) derivatives, energy derivatives, base metal derivatives, precious metals derivatives, weather derivatives, and freight derivatives, among others. Some of these are settled on physical commodities (agri, energy, base and precious metals), and some are set- tled on indexes (weather, freight). Each presents variations in grade and quality based on location. For example, there may be variations in the grades of wheat that trade on different exchanges. These include soft red winter wheat that trades on CME, Australian premium wheat that trades on ASX, and hard white wheat and strong gluten wheat that trade on ZCE. Each of these variations in the un- derlying creates differences in defining derivatives products to trade, as well as in the clearing and settlement processes, and can create a bottleneck for market competitiveness. This degree of non-standardisation across commodities raises an important ques- tion for analysis: which commodities should we focus on to compare India's competitiveness on commodity derivatives markets? One approach is to focus on commodities where India has a large presence, either through production or through trade. For exam....
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....ple, India is one of the top three producers of wheat, pulses, edible oils, cotton, sugar, and spices. In some of these commodities, India is the only established exchange trading that commodity. In non-agri commodi- ties, India is one of the largest consumers of bullion, petroleum and associated products form a large component of both its imports and exports. Ministry of Finance Department of Economic Affairs 37 COMMODITY DERIVATIVES MARKET It would be in India's interest to develop an internationally competitive market for derivatives in these commodities onshore. This would attract those partic- ipants who (1) have a trading position in Indian commodities, (2) wish to take positions in them due to a match in basis, and (3) wish to trade in a deep and liquid market. The creation of such a marketplace would (1) increase the depth and liquidity of the domestic market, (2) benefit domestic participants through better price discovery and hedging effectiveness, (3) increasingly make India the centre of financial trade in these commodities, and (4) create a context for spot market reforms in line with the findings of the UNCTAD (2009) study. With this perspective, we ....
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....choose the following sets of commodities using which we propose to assess the international competitiveness of the Indian commodity markets: - • Agri commodities – wheat, sugar, cotton, soya oil and soya bean; • Non-agri commodities – gold, silver, crude oil, natural gas and base metals. 7.2 The market landscape Commodity derivatives, unlike INR derivatives or Indian equity derivatives, is a global market. From the perspective of trading commodity derivatives, where India is the only market, there are three possible venues: 1. Onshore exchanges: these trade only futures since options are prohibited by law. The largest Indian exchanges by type of commodity are as follows: • National Commodity Derivatives Exchange (NCDEX) for agri, and • Multi Commodity Exchange (MCX) for base and precious metals and energy. There is no organised OTC market in India for commodity derivatives. This seg- ment is constrained by FCRA, 1952, which allows only a specific type of contract to be traded outside exchanges. 2. Offshore exchanges: there are several large global commodities exchanges that are competitors. Several of these are organised as gl....
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....obal complexes, with separate ex- changes within them trading a commodity group. The largest of these by their ranking in the World Federation of Exchanges lists are as follows: • Chicago Mercantile Exchange group (CME) – agriculture, metals, energy. • Intercontinental Exchange (ICE) Futures Europe - energy. • London Metal Exchange (LME) - all metals. • Dalian Commodity Exchange (DCE) – soybean, soy oil and corn. • Zhengzhou Commodity Exchange (ZCE) – wheat, sugar and cotton. • Shanghai Futures Exchange (SHFE) - all metals. These exchanges accounted for 95% of global exchange traded volumes in all com- modities in 2013. 3. Offshore OTC: these are markets with two distinct groups that provide derivatives: financial institutions that have commodity trading desks, and commodities trading firms. The second set can be further broken into two: private firms, 14 and state trading boards of various countries. 15 Financial institutions have a small presence in these markets, since they restrict themselves to providing financial settlement on contracts rather than physical set- tlement. The dominant participants are ....
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....the grain trading firms. 14There are 6-8 large firms including Agrico, Archer Daniel Midland (ADM), Bunge, Cargill, Glen- core, Louis Dreyfus, Nidera, and Noble Grain. 15These include Argentina, Australia, Canada, France, Russia, and Ukraine. Ministry of Finance Department of Economic Affairs 38 COMMODITY DERIVATIVES MARKET Table 7 Size of the exchange traded commodity derivatives market Traded Value Major Exchanges Traded Volume (Mn contracts) (Bn USD) India NCDEX MCX Total 1.11 0.76 1.06 7.16 2.17 7.92 International CME 3.17 237.66 ICE Europe 1.32 124.49 LME 0.69 59.55 DCE 2.85 31.7 SHFE 2.62 40.62 ZCE 2.14 12.71 Total 13.31 506.82 Source for India: Forwards Market Commission Source for international markets: World Federation of Exchanges The size of the global exchange traded commodity derivatives market (daily av- erage turnover) in 2013 is given in Table 7. 7.2.1 Competitors The exchanges listed in the previous section are considered as the international competitors to the Indian commodities derivatives markets. Of these, three are exchanges in China that have gained global market share over the last two to three years. T....
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....here is a large OTC market segment in commodity derivatives that trades in Chicago, New York, London, and Singapore. In Dec 2013, the notional amount outstanding in this market was USD 2.2 trillion (BIS (2013)). 7.3 Review of the factors of competitiveness 7.3.1 Capital controls Two elements of capital controls need to be assessed for access to the commodity derivatives market: Inward access – whether foreign participants can participate in onshore markets - and Outward access whether domestic participants have access to offshore markets. Inward access - - Foreign participants are not permitted to participate in the commodity deriva- tives market. Part of this is due to the lack of regulatory coordination: for- eign participants into India are registered under the FPI regime, which falls under SEBI. Commodity derivatives do not form a part of SEBI list of securi- ties in which FPIs can invest because they fall under the regulatory purview of FMC. The other is that foreign firms are not allowed to participate in commodity Ministry of Finance Department of Economic Affairs 39 COMMODITY DERIVATIVES MARKET derivatives except through the route of setting up ....
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....100% subsidiaries under the FIPB guidelines. Under this mechanism, these foreign firms become incorpo- rated domestic entities. Outward access Domestic firms have been permitted by RBI to participate in both exchange traded and OTC markets for commodity derivatives offshore (RBI Circular: Jan- uary, 2012). However, firms are only permitted to take positions up to their ex- plicit exposure to underlying trade. This is permitted in most commodity deriva- tives.16 These firms can only take these positions through AD category-I banks, to whom the firms have to demonstrate these exposures. The only firms permitted to take offshore derivatives positions against their do- mestic trade in addition to their external trade are domestic oil refining compa- nies and domestic users of aviation turbine fuel. The ability to hedge price risk on domestic positions are special dispensations that are available only to these categories of firms. This is an important factor in evaluating the competitiveness of the onshore mar- kets. While foreign participants are not allowed onshore, domestic firms are al- lowed to use the offshore markets with constraints. In contrast, offshore excha....
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....nges or OTC markets in commodity derivatives in the OECD countries place no constraints on market access. The only requirements for participation are KYC or CDD and the criteria for trading on exchanges. 7.3.2 Vibrant domestic market A vibrant domestic market in commodity derivatives can be created if (a) there is wide access available to a large variety of participants, (b) there exists a ro- bust and consistent legal and regulatory framework, and (c) the market readily provides products and services that are required by various participants. Wider access Only firms and individuals are permitted to take positions in commodity deriva- tives markets onshore. Domestic financial institutions are not permitted, either because of explicit regulation or because there is a lack of regulatory clarity on whether they can use these derivatives. For examples, banks are explicitly not permitted by Section 8 in the Banking Regulation Act. Similar regulatory restric- tions hold for mutual funds, insurance firms and pension funds. Large public sector firms that have exposure to trade, such as Food Corporation of India, State Trading Corporation of India, and MMTC Ltd, do not parti....
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....cipate in this market. Large oil refining and marketing firms access the more liquid offshore markets for their needs. The Government of India has taken positions on global exchanges like CME due to lack of depth in the onshore exchanges (for example, during the high global food prices of 2005 and 2006). 16The exceptions are gold, silver and platinum. Ministry of Finance Department of Economic Affairs 40 COMMODITY DERIVATIVES MARKET Robust legal and regulatory framework The FCRA, 1952 is the primary legislation for the commodity derivatives market, but there are several other laws that create uncertainty while undertaking a com- modity derivatives transaction. For example, while the FCRA is under the union list, trades on the underlying commodities fall under the state list for agricultural commodities. Other examples of laws that need to be considered for a complete understanding of the applicable legal framework include the following: • Warehousing (Development and Regulation) Act, 2007. • Food Safety and Standards Act, 2006. • APMC Act. • Essential Commodities Act, 1955 - state level storage controls. ◠Price- and quantity-linke....
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....d interventions by central and state government. Besides a complex legal framework, the regulatory framework also presents un- certainties. This is primarily because even though FMC has delegated powers from the central government, it is not an autonomous regulator like SEBI or RBI.17 FMC has limited powers of surveillance, investigation and enforcement and lacks both capacity and resources for regulating a complex market such as commodity derivatives. Even at the FSDC, FMC was only allowed representa- tion as recently as Dec 2013. This leads to concerns about inter-regulatory coor- dination. One reason that the Indian commodity derivatives ecosystem is weak is that the large financial firms do not trade due to a lack of regulatory certainty. This suggests a lack of comfort about commodity derivatives at the other finan- cial sector regulators. Lack of depth in services and products There is limited availability of products and services that can be offered in this market onshore, driven by constraints that are both legal and regulatory in na- ture. The following are examples. • The FCRA permits commodity derivatives only on goods.18 This is a severe con- stra....
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....int. For example, since an index is not a good, derivatives on commodity groups are not permitted. This also implies that Indian exchanges cannot offer derivatives on freight and weather. • The FCRA does not permit options. • Cash-settled contracts do not exist. 17 Budget 2015 announced the proposal to merge FMC with SEBI. The merger of FMC and SEBI, along with the consolidation of secondary trading in debt securities under SEBI, empowers SEBI as a one-stop-shop regulator for all secondary trading. This can lead to measures to provide ben- efits of consolidated portfolios to both domestic and foreign investors, including common clearing and consolidated portfolio level margining, single KYC etc. Till now, FMC was not an independent regulator like SEBI and had limited powers of surveillance, investigation and enforcement. SEBI, en- abled through the SEBI Act, has better regulatory infrastructure and resources that will now become available to the commodity derivatives segment. In addition several legal and regulatory hurdles in the commodity derivatives market may now be considered for easing. This includes: (1) allowing foreign participants, (2) allowing p....
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....roducts such as options of commodities and derivatives on un- derlying such as indexes, weather and freight. The implementation of this merger will be the key challenge. The organisation structure of FMC merged into SEBI will be critical to ensure that both the elements (1) the unique features of commodity derivatives; and (2) the advantages of a consolidated portfolio and unified regulator, are appropriately addressed in this merger. 18 Chapter 2 of FCRA, 1952 defines goods as every kind of movable property except actionable claims, money and securities. Ministry of Finance Department of Economic Affairs 41 COMMODITY DERIVATIVES MARKET • OTC contracts are not permitted under the FCRA, except in the form of non-transferable specific delivery (NTSD) contracts 19 and transferable specific delivery (TSD) con- tracts. At the exchanges, the regulatory process for product approval is a bottleneck for product innovation. Regulatory approval is required even for relaunching an ex- isting contract on expiry. This takes away operational flexibility from exchanges with regard to product innovation. These are severe restrictions on a vibrant domestic ecosystem where fo....
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....reign and domestic participants with an interest in taking commodity exposure can trade. In contrast, access, legal and regulatory clarity and flexibility of product and ser- vice innovation is taken for granted in the older (OECD) commodity exchanges and in the global OTC markets for commodity derivatives. 7.3.3 Position limits Position limits on commodity derivatives at the Indian exchanges are defined at both the client and trading member levels. Across commodities, trading mem- ber limits are typically three to five times the limits for clients. This sets a limit on how large a client base the trading member can create. Offshore exchanges define position limits for near-month and all-month positions, which is a way of managing the concentration limits without constraining the business develop- ment of the trading member. Position limits on Indian exchanges are smaller than those offshore in terms of number of contracts. This is compounded by onshore contract sizes being smaller than contract sizes offshore. For example, the size of a wheat contract on CME is 136 metric tonnes, while that on NCDEX is 10 metric tonnes. Similarly, a crude oil contract on NYMEX is ....
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....1000 barrels, while that on MCX is just 100 barrels. A comparison of the onshore and offshore position limits for agri com- modities is presented in Table 8 and that for non-agri commodities is presented in Table 9. 7.3.4 Regulatory risk There are three main sources of regulatory risk in the Indian commodity deriva- tives market: (1) frequent bans on futures trading, (2) restrictions on trade in underlying commodities, and (3) the multiplicity of regulatory jurisdiction and protection of regulatory turf. Bans on futures trading Banning of commodity futures contracts is a large source of regulatory uncertainty. Examples of bans on trading of commodity derivatives are presented in Table 10. Bans on trading arise out of concerns that manipulation in futures market leads to 19NTSD contracts on all the 54 specified commodities have been freed up for trading from gov- ernment regulation or prohibition under Section 17 of the FCRA vide Ministry of Consumer Affairs Notification S.O. 369 (E), 1st April, 2003. The Ministry vide its notification S.O. 617(E) dated 27th May, 2003 exempted all non-transferable specific delivery (NTSD) contracts in 37 commodities from the operati....
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....on of Section 17 read with Section 18(3) of the Act in the whole of India. Consequently, party-to-party contracts for sale of goods involving delivery and beyond eleven days do not attract any regulatory/prohibiting provisions under the FCRA. Ministry of Finance Department of Economic Affairs 42 COMMODITY DERIVATIVES MARKET Table 8 Position limits for agri commodity derivatives The values in the table show client level limits for onshore exchanges, while those for offshore in- dicate spot month limits. Values within parentheses indicate member-level limits on onshore ex- changes, while figures within parentheses for offshore exchanges indicate cumulative limits for all contracts. Number of contracts ('000) Commodity Onshore Offshore CME ICE DCE ZCE Wheat Sugar Cotton Soybean Soy Oil 0.6 (3) 0.6 (12) 2.0 (10) 2.5 (5) * * * * 2.0 1.5 (6) 1.0 (4.5) 0.6 (9) * (15) 0.6 (1.8) 0.5 (8) * indicates that the commodity is traded but that there is no position limit defined in contract specifications Table 9 Position limits for non-agri commodity derivatives Number of contracts ('000) Category Commodity Onshore Offshore CME ICE LME Bullion Gold ....
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.... Silver 2.5 (12.5) 2 (10) 3 (6) 1.5 (6) 3 (6) * 1.5 (6) * Energy Crude Oil Natural Gas 4 (20) 10 (20) 4.8 (24) 5 (10) Base metals Aluminium 3 (15) 0.2 (2) Copper Lead 5 (25) 0.2 (5) 0.36 (1.8) * SHFE * Nickel Zinc 2.4 (12) 0.72 (3.6) * indicates that the commodity is traded but that there is no position limit defined in contract specifications Ministry of Finance Department of Economic Affairs 43 COMMODITY DERIVATIVES MARKET Table 10 Bans on futures trading Commodity Tur, Urad Rice Trading suspended on 23rd Jan, 2007 27th Feb, 2007 Suspension revoked Ongoing Ongoing Wheat 27th Feb, 2007 Chana, Soya Oil 7th May, 2008 14th May, 2009 30th Nov, 2008 Rubber, Sugar 26th May, 2009 Guar seed, guar gum 27th Mar, 2012 30th Sept, 2010 10th May, 2013 increases in the spot prices of commodities. However, the evidence establishing this is weak. Studies in India (Abhijit Sen Committee Report (2008)) and elsewhere (IOSCO (2010)) find that unexpected increases in prices and volatility in the spot market have their source in local demand and supply factors. There is also no evi- dence of whether an outright ban prevents future manipulat....
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....ion or helps in improv- ing market quality. In other contexts, studies show that outright bans on financial services and products have an adverse effect on the welfare, both for direct users as well as for the overall economy Sane and Thomas (2013). Market manipulation is often an outcome of a mismatch between the size of futures positions and the deliverable supply of the underlying, and the threat of delivery keeps it in check. This suggests that the policy should deliver the following: • Active surveillance by the commodity derivatives market regulator and effec- tive enforcement (as opposed to bans) • A coherent legal framework and physical infrastructure to ensure effective delivery for settlement of contracts. Conflicts of inter-regulatory jurisdiction The regulatory jurisdiction over domestic FIs and foreign investors lies with dif- ferent financial sector regulators. RBI has jurisdiction over all foreign exchange transactions through FEMA and is the regulator for banks. SEBI has jurisdiction over all foreign participation through the FPI regime and is the regulator for MFs. IRDA and PFRDA are the regulators for insurance and pension funds, respec....
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....tively. Warehousing, which is a critical requirement for delivery against contracts, is reg- ulated by a different regulator, WDRA. For a higher domestic and foreign participation in commodity derivatives, each of these regulators will need to allow their respective constituencies greater freedom to use these derivatives. These regulators will need to issue operational clarity regarding their participation from time to time. All this requires inter-regulatory coordination, which is currently lacking in the Indian market. Coordination between FMC and WDRA to develop the physical in- frastructure for delivery and with the RBI to link bank-based finance to this system also requires regulatory coordination. 7.3.5 Frictions Frictions in this market arise in the form of elements that hamper effective deliv- ery for the settlement of derivatives contracts and state interventions that ham- per the functioning of the market. The following are the examples of factors that affect timely delivery of the un- derlying goods for settlement, which arise due to unanticipated shocks to the Ministry of Finance Department of Economic Affairs 44 COMMODITY DERIVATIVES MARKET quantit....
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....y available for delivery: • The government intervenes to dictate the market price of a commodity. This changes the economic viability of traders in the commodity and changes how they will store and warehouse the commodity. UNCTAD and World Bank Joint Mission Report (1996) and Guru Committee Report (2001) noted the pervasive government inter- vention in wheat, rice and sugar, which then adversely affected the viability of derivatives on these commodities. • State governments exercise controls on storage and stock limits without warning and with short notice. Such actions in the middle of a delivery cycle on products can cause gluts or shortfalls for the settlement of a specific commodity. • Regulatory changes on the grade or quality to be permitted for delivery. One such example was when FMC stipulated that all agri commodities' grades for deliv- ery against contracts needed to be FSSAI compliant. This caused shortfalls in the available quantity for delivery due to a mismatch between the quality required by regulation and the quality available in the market. • Large variations in the quality of warehouse and logistics infrastructure, which eit....
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....her impact the deliverable quantity and quality or the cost of delivery. All these are negative factors with respect to the trade in the underlying, which also has an indirect but adverse effect on the derivatives. The extent and per- sistence of such frictions is much higher in the onshore markets, especially in comparison to offshore OECD competitor markets. 7.3.6 Tax policy In addition to taxes on transactions and taxes on participants, commodity deriva- tives market are also impacted by a third element of taxation: indirect taxes on movement of goods. Transaction taxes Commodities Transactions Tax (CTT) was announced in the 2013 budget, as appli- cable to non-farm commodities such as gold, silver and base metals and processed farm commodities such as sugar, guar gum and mentha oil. All pure agricultural commodities are exempt from CTT.20 CTT is calculated at 0.01% of the transaction value or Rs.10 per lakh of the business for sellers. Ray and Malik (2014) find that after imposition of CTT, OI and traded volumes fell, whereas the cost of transaction increased, for those commodities where CTT was applicable. Stamp duty is applicable on commodity derivatives trans....
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....actions, with different stamp duty rates across states. The states can change the magnitude of the stamp duties at will.²¹ This not only adds to transaction costs but also creates operational problems of compliance. The Indian Stamp (Amendment) Bill, 2014, proposes a uniform stamp duty at 0.03% of transaction value to be paid by seller through ex- changes and will serve to reduce the uncertainty of this element of transactions cost on Indian commodity derivatives. Indirect taxes There are indirect taxes that need to be paid for movement of goods, which includes mandi tax (APMC Act at the state level), sales tax (intra-state) and VAT (inter-state). These taxes add to the cost of delivery against contracts and increase the cost of 20 There are 23 pure farm commodities defined in the FCRA. 21 West Bengal lands a blow on commodities trading, Mint, April 28, 2014 Ministry of Finance Department of Economic Affairs 45 COMMODITY DERIVATIVES MARKET trading. The proposed Goods and Services Tax (GST) Act will remove inter-state disparities in these taxes and facilitate free movement of goods across states.²² Tax on participants From the perspective of direct ta....
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....xation of participants, commodity derivatives trad- ing on specified exchanges was declared to be non-speculative in the 2013 budget: this allowed participants to set off gains and losses on commodity derivatives trans- actions with gains and losses from their business. However, in the 2014 budget, the non-speculative status was permitted only for transactions for which CTT was paid. This implies that transactions on pure farm commodities (exempt from CTT) will be deemed speculative, while those on non-farm commodities and processed farm commodities will be deemed non speculative. This guideline appears to be a un- reasoned duplication of the guideline in the securities markets where transactions with STT are deemed non-speculative. It is an example of the lack of coherent pol- icy on the commodity derivatives markets. An additional element of tax policy reform that is currently not applicable to these markets, but will need to be addressed, is the question of source-based tax- ation for foreign participants when they are allowed in these markets. Reforms policy also needs to reduce the costs arising due to tax policy issues in order to improve the competitiveness o....
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....f Indian commodities derivatives. Analysis 7.3.7 Margins Table 11 provides a comparison of the basic margins structure on Indian and competitor exchanges. The onshore margins defined in the contract specifica- tions are comparable with offshore margins. However, special regulatory mar- gins are imposed onshore on an ad hoc basis from time to time. These not only increase the cost of transactions for participants but also add to the uncertainty under which they have to operate. 7.3.8 Trading time Table 12 presents a comparison of trading time across onshore and competitor offshore exchanges. In contrast to limited trading hours for exchange traded currency and equity derivatives, trading hours on Indian commodity derivatives exchanges are not a constraint for participants, even though they are shorter than trading hours on CME and LME. 7.4 Summarising the factors: India vs. competitor Box 6 provides a summary of the eight factors for agri commodity derivatives traded on NCDEX and CME. This is ranked in the order of importance of the factors for this market. 22 Budget 2015 announcement to implement GST by 1st April, 2016. This will lead to a simplifica- tion of th....
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....e indirect tax structure and a reduction in the indirect cost burden on movement of goods. Ministry of Finance Department of Economic Affairs 46 46 COMMODITY DERIVATIVES MARKET Table 11 Margin comparisons for agri and non-agri commodity derivatives (As% of contract value) Agri commodities Onshore Offshore NCDEX CME ZCE DCE Wheat 5.0 5.0 5.0 Sugar 5.0 5.6 6.0 Cotton 5.0 5.7 5.0 Soybean 5.0 4.4 5.0 Soy Oil 5.0 5.2 5.0 Non-agri commodities Onshore Offshore MCX CME LME SHFE Bullion Gold 5.0 Silver 5.0 Energy Crude Oil 5.0 Natural Gas 6.9 5035 5.1 4.0 9.5 4.0 3.1 8.0 5.1 Base metals Aluminium 5.0 6.0 Copper 5.0 2.0 Lead 5.0 8.1 555 5.0 5.0 5.0 900 Nickel 8.6 8.9 Zinc 5.0 7.5 5.0 Table 12 Comparison of trading times across exchanges Trading Venue CME (Sugar and Gold) LME CME (Grains) NCDEX ASX SFE Bursa Malaysia DCE/SHFE/ZCE Trading duration (hours) 23 18.5 16.5 13.5 8.0 5.5 3.5 Ministry of Finance Department of Economic Affairs 47 COMMODITY DERIVATIVES MARKET Box 6. Analysis and prioritisation of the eight factors Factor 1. Capital controls 2. Vibrant domestic market 3. Position limits....
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.... 4. Regulatory risk 5. Frictions 6. Tax policy 7. Margin 8. Trading time NCDEX High CME None Weak Strong Constraint Not a constraint High High Low a. CTT applicable b. Stamp Duty c. Source based Ad hoc 13.5 hours Low a. No CTT b. None c. Residence based Fixed 23 hours 7.5 Impact on canonical users The two user categories identified as users of this market are the following: 1. Large domestic firms and domestic subsidiaries of foreign companies. 2. Foreign commodity trading firms. Box 7 presents how the eight factors that shape competitiveness affect the par- ticipation of these users. Ministry of Finance Department of Economic Affairs 48 COMMODITY DERIVATIVES MARKET Box 7. The eight factors mapped to two users Factor 1. Capital controls Large domestic firm/Domestic subsidiary of foreign firm Both inward and outward access allowed. 2. Vibrant domestic market No 3. Position limits 4. Regulatory risk 5. Frictions 6. Tax policy institutional participation. Lack of robust legal and regula- tory framework. Lack of product availability Small compared to size of trade in commodity. Small compared to offshore limits. Contract sizes ....
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....small compared to offshore Frequent bans on futures trading. Dispersed regulatory jurisdiction Constraints on delivery. Price and quantity controls on agri com- modities. Source based direct tax, not spec- ulative only for transactions on which CTT applicable. CTT appli- cable on non-farm and processes agri commodities. Stamp duty ap- plicable, rates vary across states. Indirect taxes on movement of goods add to costs. Foreign investors No direct access to onshore mar- kets even for SEBI-registered for- eign participants. Not applicable. Not applicable. Not applicable. Not applicable. Not applicable. 7. Margins Adhoc application of special mar- gins onshore. Not applicable. 8. Trading Time 13.5 hours, not a constraint. Not applicable. 7.6 A market report card for commodity derivatives The market report card for commodity derivatives is measured for agri and non- agri commodities futures separately. For each commodity, the volume of trade from one or two of the largest offshore exchanges is used as a comparison for the Indian exchanges. Since contract specifications across commodity derivatives exchanges vary widely across the world, the measureme....
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....nt of volume of trade is based on the number of traded contracts. While comparing the onshore ex- changes with offshore competitor exchanges, the smaller lot size of the contracts on the Indian exchanges needs to be considered. The following are the main findings from the report card for agri commodities futures: ⚫ Both the lot sizes and the traded volume of contracts in India are much smaller than those in competitor offshore exchanges. • The traded volume to open interest is smaller in Indian exchanges relative to the competitor offshore exchanges. The following are the main findings from the report card for non-agri commodi- ties futures: Ministry of Finance Department of Economic Affairs 49 COMMODITY DERIVATIVES MARKET • The traded volume of contracts in India is currently much smaller than that in international exchanges, although till April-June 2013, traded volumes on MCX were in line with the competitor exchanges. • Lot sizes on Indian exchanges are much smaller than those on competitor exchanges. • For non-agri commodities as well, traded volume to the open interest is smaller for the Indian exchanges compared to the compet....
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....itor exchanges. The detailed market report card is presented in Appendix C. 7.7 Policy proposals A set of policy reforms to improve the international competitiveness of the In- dian commodity derivatives is listed and classified into short, medium and long term based on the nature of the reform and the time that may be required to implement them. 1. Short-term actions (a) Reduce or eliminate regulatory constraints on banks and MFs to participate in commodity derivatives. (RBI, SEBI, DEA, FMC) (b) Implement Handbook (2013) procedures for setting position limits and mar- gins. (FMC) (c) Create a high-level committee of FMC, WDRA, RBI to enable the creation of the following: • A robust warehousing system to strengthen delivery against contracts • A well-functioning market for warehouse receipt finance. (d) Extend the non-speculative status on direct taxes for all exchange traded com- modity derivatives contracts. (DEA, CBDT) 2. Medium-term goals (a) Allow foreign entities that have exposure to commodities through trade or finance to participate in Indian commodity derivatives. (DEA, FMC, SEBI, RBI) This requires the following: • Creating a mech....
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....anism for registering commodity-specific participants with FMC. • Co-ordinating with FMC, RBI and SEBI to avoid multiple registration and compliance requirements. (b) Implement the following key proposals of the FCRA Amendment Bill, 2010: • Provide statutory powers to FMC to become an independent regulator. • Widen FMC's powers on investigation, enforcement and imposition of penalties. • Make SAT the appellate body for FMC orders. • Widen definition of commodity derivatives to include goods, services, activities and events. • Permit options. • Permit cash-settlement of index-like products. • Demutualisation and corporatisation of all recognised associations. • Set up a clearing corporation. Ministry of Finance Department of Economic Affairs 50 (DEA) COMMODITY DERIVATIVES MARKET (c) Enhance regulatory capacity and resources at FMC. (DEA) (d) Devolve contract design, product innovation and trading time-related deci- sions to exchanges to increase their operational flexibility. These should be monitored by FMC. (FMC). (e) Set up an expert committee to rationalize margins and position limits. (DEA, FMC) The....
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.... agenda for this committee should be to rationalize these while taking into consideration the following: • The diverse nature of the underlying commodities • Position limits and margins on competitor offshore exchanges. (f) Devolve position limit and margin setting on exchanges to provide them with operational flexibility. These should be monitored by FMC. (FMC) (g) All regulation making by FMC must proceed as per regulatory governance norms laid out in the Handbook (2013). (FMC) (h) Remove the power to ban commodity derivatives trading. If at all the central government chooses to retain this power, it should do so with detailed and well-defined triggers that are readily measured using public data. This is crucial to ensure regulatory clarity for participants. (DEA) (i) Increase priority on implementing GST. (Central and state governments) (j) Rationalise stamp duty through the India Stamp (Amendment) Bill, 2014. (Central and state governments) 3. Long term goals (a) Rationalise and reduce legislative contradictions around the interaction of derivatives and spot market for commodities. (Central and state govern- ments) (b) Set up an expert committee t....
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....o evaluate how a full-fledged OTC market for commodity derivatives can be created. This will also require an amendment to the FCRA, which currently does not permit an OTC market in commodity derivatives. (DEA) (c) Move to a residence-based taxation regime over the longer term. (DEA, CBDT) Ministry of Finance Department of Economic Affairs 51 SUMMARY OF POLICY RECOMMENDATIONS 8 Summary of policy recommendations The policy proposals for improving international competitiveness of the Indian financial sector fall into three categories: 1. Proposals targeting key economic decisions at the level of the central government. For example, limitations on capital account convertibility or policy of source-based taxation. 2. Proposals with regards to administrative aspects of implementation of key eco- nomic decisions. For example, documentation and compliance requirements or lack of clarity on tax administration or uncertainty in regulation. 3. Proposals on market microstructure-linked issues. For example, design of position limits and margins or market trading time. To achieve these policy proposals, a host of reforms addressing these gaps need to be undertaken. The repor....
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....t identifies these reforms, along with the implement- ing agencies for them. It also recommends a phasing of the reform process into the following sets by the likely time taken for implementation: • Short-term actions: Table 13 show measures that can be implemented within the next six months. • Medium-term goals: Table 14 have measures that first need to be evaluated, but can most likely get implemented in a one- to two-year time frame. • Long-term goals: Proposals in Table 15 need significant reversals of the existing policy and will likely require implementation over a longer time frame. Ministry of Finance Department of Economic Affairs 52 62 SUMMARY OF POLICY RECOMMENDATIONS Table 13 Summary of policy recommendations: short-term actions Proposals Currency derivatives market • Clarify ambiguities in direct tax treatment of ETCD transactions for do- mestic firms. ⚫ For foreign participants, eliminate the regulatory uncertainty regarding the Singapore and Mauritius tax treaties. • Rationalise KYC and compliance requirements for non-resident partici- pants in line with CDD requirements under FATF. • Remove documentatio....
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....n requirements for taking positions in the ETCD market that were introduced in the RBI Circular: June (2014b). Implementing agency CBDT, DEA CBDT, DEA SEBI RBI • Remove restrictions on cancelling and re-booking OTC contracts. ◠Remove restrictions on participation by domestic financial institutions. • Devolve trading time linked decisions to exchanges and AD I Banks. • Devolve product innovation decisions from regulators to exchanges. • Avoid banning market segments, participants or products. All regula- tory intervention should be as per Handbook (2013) procedures. Equity derivatives market RBI RBI, SEBI, IRDA SEBI, RBI SEBI DEA, RBI, SEBI • Rationalize KYC and compliance requirements for non-resident partici- pants in line with CDD requirements under FATF. • Allow access to all foreign participants that meet the FATF CDD require- ments. • Eliminate the regulatory uncertainty about availing treaty benefits under the proposed GAAR. • Remove STT but without the adverse impact of higher capital gains tax. • Remove stamp duty as index derivatives are cash settled and no delivery of the underling tak....
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....es place. • Make trading and clearing rules nationality and participant neutral: (a) Allow FPIs and MFs the same list of permissible securities that are allowed to domestic participants as collateral; and (b) Allow FPIs access to ETCD market. Already implemented by RBI in June 2014. • Clarify the regulatory position on PNs. • Move towards FATF compliant CDD disclosures for PNs. • Devolve market timing decisions from regulator to exchanges. Commodity derivatives market • Remove regulatory constraints on banks and MFs to participate in com- modity derivatives. • Implement Handbook (2013) procedures for setting position limits and margins. • Create a high level committee to create of (a) A robust warehousing sys- tem to strengthen delivery against contracts; and (b) A well-functioning market for warehouse receipt finance. SEBI, DEA SEBI, RBI DEA, CBDT SEBI, DEA, CBDT SEBI, DEA, CBDT SEBI, RBI SEBI SEBI SEBI RBI, SEBI, DEA, FMC FMC FMC, WDRA, RBI • Extend non-speculative status on direct taxes for all exchange traded commodity derivatives contracts. DEA, CBDT Ministry of Finance Department of Economic Affai....
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....rs 53 SUMMARY OF POLICY RECOMMENDATIONS Table 14 Summary of policy recommendations: medium-term goals Proposals Currency derivatives market • Sign tax treaties similar to the Mauritius and Singapore treaty with other FATF-compliant countries. • Implement Handbook (2013) process for governance of the regulation making process at RBI and SEBI. ◠Set up an expert committee to rationalize position limits and margins and design a framework within which the power to set position limits and margins is devolved to exchanges. Equity derivatives market • Create a working group for common clearing among exchange traded products, equity, equity derivatives and currency derivatives, in phases. Phase I for multiple segments within a single exchange and in Phase II across exchanges, with multiple competing clearing corporations. • Implement Handbook (2013) processes for governance of the regulation making process at SEBI. • Remove regulatory restrictions on domestic FIs participation in equity derivatives. • Set up an expert committee to rationalize position limits and margins. This committee should: (a) Rationalise position limits ....
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....across all market segments; (b) Create single margin system across market segments in two phases; and (c) Rationalise margins vis-a-vis competitor markets like SGX. • Devolve margins, position limits, trading time, product innovation etc. linked decisions to exchanges, with suitable monitoring by SEBI. Commodity derivatives market • Allow foreign entities with commodity exposure to participate in Indian commodity derivatives: (a) Create a mechanism for registering commod- ity specific participants with FMC. (b) Ensure co-ordination between FMC, RBI and SEBI to avoid multiple registration and compliance requirements. • Implement the following key proposals of the FCRA Amendment Bill, 2010: (a) Provide statutory powers to FMC to become an independent regulator. (b) Widen FMCs powers on investigation, enforcement and im- position of penalties. (c) Make SAT the appellate body for FMC orders. (d) Widen definition of commodity derivatives to include goods, services, activities and events. (e) Permit options. (f) Permit cash-settlement of index like products. (g) Demutualisation and corporatisation of all recog- nised associations. • Enhance regul....
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....atory capacity and resources at FMC. • Devolve contract design, product innovation and trading time related decisions to exchanges with monitoring by FMC. Implementing agency DEA DEA, RBI, SEBI DEA, SEBI SEBI, RBI SEBI, DEA SEBI, RBI, IRDA SEBI, RBI SEBI DEA, FMC, SEBI, RBI DEA DEA FMC • Set up an expert committee to rationalize margins and position limits taking into account (a) the diverse nature of the underlying commodities; and (b) position limits and margins on competitor offshore exchanges. • Devolve position limit and margin setting to exchanges with monitoring by FMC. FMC DEA, FMC • Implement Handbook (2013) process for governance of regulation mak- ing at FMC. FMC • Remove Central government's power to ban commodity derivatives trading. DEA • Focus on implementing GST. • Rationalise stamp duty through the India Stamp (Amendment) Bill, 2014. Central and state gov- ernments Central and state gov- ernments Ministry of Finance Department of Economic Affairs 54 SUMMARY OF POLICY RECOMMENDATIONS Table 15 Summary of policy recommendations: long-term goals Proposals Currency derivatives market â....
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....¢ Move to a residence-based taxation regime over the longer term. • Consider a time-bound plan for the internationalisation of the INR, in line with the plans of the Chinese government for the internationalisation of the Renminbi. Equity derivatives market • Move to a residence-based taxation regime over the longer term. • Set up an expert committee for creating an onshore OTC market for eq- uity derivatives. Amend SCRA suitably for this to happen. Commodity derivatives market • Move to a residence-based taxation regime over the longer term. • Rationalise and reduce legislative contradictions around the interaction of derivatives and spot market for commodities. â— Set up an expert committee to evaluate setting up of a full fledged OTC commodity derivatives market. Amend FCRA suitably for this to happen. Implementing agency DEA, CBDT DEA DEA, CBDT DEA, SEBI DEA, CBDT Central and state gov- ernments DEA Ministry of Finance Department of Economic Affairs 55 A REPORT CARD FOR THE MARKET FOR CURRENCY DERIVATIVES A A report card for the market for currency derivatives Table 16 The report card for currency derivatives ....
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....Size of Participation Traded Volumes (USD Billion) Open Interest (USD Billion) Cost Impact Cost (%) Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Exchange India 1.74 2.12 2.45 2.79 2.45 2.87 1.33 1.33 2.48 4.19 4.62 4.47 0.145 0.210 0.095 0.105 0.099 Intl. 1.12 1.38 1.20 1.35 1.31 1.51 1.18 1.05 1.19 2.08 1.99 2.01 OTC India 15.48 18.43 21.33 18.29 17.93 16.14 Intl. Ministry of Finance Notes: Q1 denotes January-March, Q2 denotes April-June, Q3 denotes July-September, and Q4 denotes October-December. Example: Q2-13 denotes April-June, 2013; Q1-14 denotes January-March, 2014 1 Traded volume for Indian exchanges is a sum of the volumes in USD-INR futures across NSE, MCX-SX, BSE and USE. The international exchanges traded volume is the USD-INR futures on DGCX. The traded volume for India OTC market is calculated using the outright forwards and swaps data from the RBI weekly statistical supplement. It includes all FCY-INR forwards and swaps. Department of Economic Affairs 2 Open interest is calculated using daily NSE bhavcopy data. 3 Impact cost is reported....
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.... for a transaction of USD 1 million, from snapshots of the NSE limit order book costs for India, and Thomson Reuters quotes for OTC India and OTC Intl. markets. *Blank fields indicate that data are currently not available. 56 Size of Participation Traded Volumes Open Interest² Cost Impact Cost³ (USD Billion) (USD Billion) (%) Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Exchange India 1.56 1.29 1.84 1.80 2.61 2.08 3.43 3.37 3.36 3.04 4.40 4.92 Intl. 0.52 0.60 0.82 0.85 0.95 0.36 6.22 7.54 8.27 8.76 9.78 7.95 0.006 0.005 0.043 0.022 0.005 0.021 0.019 0.004 0.004 0.018 0.005 0.014 B A report card for the market for equity derivatives Table 17 The report card for equity index futures Ministry of Finance A REPORT CARD FOR THE MARKET FOR EQUITY DERIVATIVES Q1 denotes January-March, Q2 denotes April-June, Q3 denotes July-September, and Q4 denotes October-December. Example: Q2-13 denotes April-June, 2013; Q1-14 denotes January-March, 2014 1 Traded volumes for India are summed across Sensex futures on BSE, Nifty futures on NSE and, for the international exchang....
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....e, Nifty futures on SGX for international exchange. 2 Open interest is calculated using daily NSE bhavcopy data, daily BSE bhavcopy data, and Thomson Reuters trades for SGX. 3 Impact cost is reported for a transaction of Rs.1 million for Nifty futures, from market-by-price data from NSE, and Thomson Reuters quotes for SGX. Notes: Department of Economic Affairs 57 Size of Participation Traded Volumes¹ (USD Billion) Open Interest² (USD Billion) Cost Impact Cost³ (%) Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q4-13 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Options India 20.90 18.11 Intl. 24.41 42.86 62.04 36.28 16.88 0.003 0.003 0.003 0.003 0.002 0.006 17.14 0.18 0.25 22.01 22.08 22.33 22.38 0.27 0.33 0.25 0.27 0.417 0.283 0.481 0.397 0.429 0.506 Table 18 The report card for equity index options Ministry of Finance A REPORT CARD FOR THE MARKET FOR EQUITY DERIVATIVES Q1 denotes January-March, Q2 denotes April-June, Q3 denotes July-September, and Q4 denotes October-December. Example: Q2-13 denotes April-June, 2013; Q2-14 denotes April-June, 2014 1 Traded volumes for India are summed across Sensex options on BSE and Nifty....
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.... options on NSE. Traded volumes for the international exchanges include Nifty options from SGX. interest is calculated using daily NSE bhavcopy data, daily BSE bhavcopy data, and Thomson Reuters trades for SGX. Notes: 2 Open 3 Impact cost is for a transaction of Rs.1 million for at-the-money Nifty options, from market-by-price data from NSE, and Thomson Reuters quotes for SGX. *Blank fields indicate that data are currently not available. Department of Economic Affairs 58 C A report card for the market for commodity derivatives Table 19 The report card for agri-commodity derivatives A REPORT CARD FOR THE MARKET FOR COMMODITY DERIVATIVES Size of participation Traded Volumes Open Interest¹ (Mn Contracts) (Mn Contracts) Cost Impact Cost² (Percentage) Q2-13 Q4-13 Q1-14 Q2-13 Q4-13 Q1-14 Q2-13 Q4-13 Q1-14 India Wheat Sugar Cotton NCDEX 0.01 0.01 0.02 NCDEX 0.15 0.06 0.14 0.08 0.02 0.02 MCX/NCDEX 1.38 0.86 1.38 0.32 0.20 0.28 Soyabean Soya Oil NCDEX 0.89 1.57 1.11 0.20 0.34 0.32 NCDEX 1.07 1.01 0.76 0.23 0.27 0.29 Intl. Wheat CME/ZCE 8.13 6.76 9.27 0.60 0.96 0.93 Sugar ICE/ZCE 48.03 27.92 48.26 3.59 3.10 ....
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....3.09 Cotton ICE/ZCE 4.90 2.66 4.33 0.62 0.52 0.64 Soyabean CME/DCE Soya Oil CME/DCE 16.44 58.34 59.69 43.99 16.17 17.16 1.52 1.16 1.44 3.10 3.89 3.63 Notes: Ministry of Finance Department of Economic Affairs Q1 denotes January-March, Q2 denotes April-June, Q3 denotes July-September, and Q4 denotes October-December. Example: Q2-13 denotes April-June, 2013; Q1-14 denotes January-March, 2014 1 Open interest on Indian, US and UK exchanges indicates maximum open interest, while that on Chinese exchanges indicate end-of-month open interest. 2 Data for computing impact cost are currently not available. 59 Size of participation Traded Volumes Open Interest¹ Cost Impact Cost² (Mn Contracts) (Mn Contracts) (Percentage) Q2-13 Q4-13 Q1-14 Q2-13 Q4-13 Q1-14 Q2-13 Q4-13 Q1-14 Table 20 The report card for non-agri commodity derivatives Ministry of Finance India Gold MCX 16.28 5.70 3.78 0.03 0.01 0.01 Silver MCX 23.38 9.38 10.87 0.05 0.01 0.01 Crude Oil MCX 14.95 4.24 4.06 0.20 0.01 0.01 Natural Gas MCX 8.49 3.15 6.30 0.17 0.02 0.02 Base Metals MCX 28.80 8.98 10.55 0.21 0.03 0.03 Intl. Gold CME/SHFE 19.71 ....
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.... 22.18 23.12 0.77 0.88 0.96 Silver Crude Oil CME/SHFE 29.92 132.33 149.30 0.91 1.86 1.72 Natural Gas Base Metals CME/ICE CME/ICE LME/SHFE 64.94 44.22 39.70 38.65 1.67 1.65 1.65 1.34 1.44 1.88 0.65 0.72 0.77 31.97 48.10 4.20 3.25 3.68 Department of Economic Affairs A REPORT CARD FOR THE MARKET FOR COMMODITY DERIVATIVES Q1 denotes January-March, Q2 denotes April-June, Q3 denotes July-September, and Q4 denotes October-December. Example: Q2-13 denotes April-June, 2013; Q1-14 denotes January-March, 2014 ¹ Open interest on Indian, US and UK exchanges indicates maximum open interest, while that on Chinese exchanges indicate end-of-month open interest. 2 Data for computing impact cost are currently not available. Notes: 60 REGULATORY GUIDELINES FOR CURRENCY DERIVATIVES, APR TO SEP 2014 D Regulatory guidelines for currency derivatives, Apr to Sep 2014 In 2012 and 2013, a series of regulatory actions were taken by the RBI and SEBI with regard to the currency derivatives market, both for the exchange traded and the OTC segments. These measures were meant to curb the increased volatility in the currency market. Table 21 provides the details of th....
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....ese actions and an update on their current status. Table 21 Current status of regulatory actions taken in 2012, 2013 Date of Regulation Market Segment May 2012 OTC Regulatory Action Taken Current Position Area Addressed Position limits NOOPL of banks to exclude po- sitions on exchanges Exchange Position limits OTC-Exchange Set-off Banks' limit as trading members reduced from higher of to lower of 15% of OI or US$ 100 mn Position on exchanges not al- lowed to be set off against OTC Revised in June, 2014 Revised in June, 2014 Revised in June, 2014 July 2013 Exchange Access Exchange Margins Exchange Position limits Banks not allowed to take pro- prietary positions Initial and extreme loss margins doubled Client limit reduced from higher of to lower of 6% of OI or US$ 10 mn Member limit reduced from higher of to lower of 15% of OI or US$ 50 mn Revised in June, 2014 Reversed in April, 2014 Reversed in April, 2014. Re- vised in June, 2014 On 20th June 2014, the RBI issued two major notifications with respect to partic- ipation rules for exchange traded currency derivatives (ETCD). The first of these laid down revised guidelines for dome....
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....stic participants in ETCD (RBI Circular: June, 2014b). The second allowed foreign portfolio investors (FPI) to participate in ETCD for the first time and laid down the guidelines for their participation (RBI Circular: June, 2014a) SEBI also issues its guidelines for ETCD simultane- ously (SEBI Circular: June, 2014). Table 22 provides a comparison of the changes introduced by these guidelines with what existed before they were introduced. In September, RBI issued a circular with respect to the hedging facilities available to FPIs (RBI Circular: January, 2014). This notification allows FPIs to hedge the coupons receipts arising out of their investments in short-term debt securities (those that fall due in the following twelve months) in India. However, these hedge contracts cannot be canceled or re-booked, only rolled over on maturity if the coupon is still pending. Ministry of Finance Department of Economic Affairs 61 REGULATORY GUIDELINES FOR CURRENCY DERIVATIVES, APR TO SEP 2014 Table 22 June, 2014 RBI, SEBI guidelines for exchange traded segments Statues before Status after Type of participant Access Domestic firms Allowed AD I banks FPIs Only client pos....
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....itions allowed Not allowed Allowed Both client and proprietary positions allowed Allowed Position limits Exporter/Importer firms Other domestic firms Non-bank members Bank members FPIs Intermediary choice Exporter/Importer firms Higher of 6% of OI or USD 10 mn from April, 2014 Higher of 6% of OI or USD 10 mn from April, 2014 Higher of 15% of OI or USD 50 mn from April, 2014 Lower of 15% of OI or USD 100 mn Not allowed Any trading member Other domestic firms Any trading member FPIs Not allowed USD 10 mn without underlying exposure. Anything above based on past performance limits. OTC plus exchange posi- tion not to exceed underlying exposure USD 10 mn without underlying exposure. Anything above with contracted exposure. OTC plus exchange position not to exceed underlying exposure Higher of 15% of OI or USD 100 mn for client positions and higher of 6% of OI or USD 10 mn for proprietary positions Higher of 15% of OI or USD 100 mn, subject to NOOPL limit. OTC-Exchange set-off allowed USD 10 mn long positions without underlying exposure. Anything above with contracted exposure. Short positions only up to USD 10 mn. Limit of higher of 15% of OI or....
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.... USD 100 mn for Category I and Category II FPIs. Limit of higher of 6% of OI or USD 10 mn for Category III FPIs. OTC plus exchange position not to exceed underlying exposure Any trading member Any trading member till USD 10 mn positions. Only AD I bank members for positions greater than USD 10 mn Any trading member. However, Custodian banks required to monitor FPI positions; thus, FPIs likely to choose bank mem- bers Documentation Exporter/Importer Not required firms Other domestic firms Not required Banks Not required Auditor's certificate for positions greater than 50% of the past performance limit. CFO declaration that exchange plus OTC position within underlying exposure Exposure documentation for positions beyond USD 10 mn. CFO declaration and auditor's certificate for exchange plus OTC position within underlying exposure AD I banks and custodian banks to respectively monitor do- mestic and FPI limits across OTC and exchange segments Underlying exposure documents for positions beyond USD FPIs Not allowed 10 mn Ministry of Finance Department of Economic Affairs 62 62 IMPACT OF RESTRICTIONS ON CURRENCY DERIVATIVES ON MARKET QUALITY E Impact of ....
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....restrictions on currency derivatives on market quality Tayal (2013) evaluates the impact of regulatory actions taken by the RBI and SEBI from 2011 to 2013 on the market quality of exchange traded currency derivatives (ETCD). For the analysis, the regulatory actions taken by RBI and SEBI are identified. For every regulatory action thus identified, measures of average market quality are computed for a twenty-day trading period before and after the regulatory action was announced. The difference between the market quality measures in the before and after periods are indicative of the impact of the regulatory actions. E.1 The regulatory actions under analysis The impact of the following regulatory actions is evaluated. Each action has been identified as an event. E1 - December 15th 2011: The Reserve Bank of India (RBI) disallowed re-booking of forward contracts on the INR. Cash or spot transactions by the Autho- rised Dealers (AD) on behalf of their clients could not be canceled or cash- settled. FIIs were disallowed from re-booking forward contracts, once can- celled. It was announced that Net Over-night Open Positions (NOOPL) were going to be reduced substantially (....
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....RBI Circular: December, 2011). E2 - May 21st 2012: NOOPL could not be set off by taking positions in other markets. Netting-off of positions in F&O on exchanges in the OTC market, and vice versa, was prohibited. The position limit for the trading mem- ber AD Category-I bank in the exchanges for trading currency F&O was reduced to the "lower of" USD 100 million or 15% of the outstanding open interest instead of “higher of" (RBI Circular: May, 2012b). E3 - July 8th 2013: RBI prohibited proprietary trading by AD Category-I banks on the exchange traded currency derivatives (ETCD). These banks could only take positions on behalf of their clients (RBI Circular: July, 2013). SEBI reduced position limits and increased margins on ETCD. Initial and ex- treme loss margins were increased by 100% of the existing rates. The client level position limit was reduced to "lower of" 6% of the total OI or USD 10 million instead of “higher ofâ€. The trading member level position limit was reduced to "lower of" 15% of the total OI or USD 50 million instead of "higher of" (SEBI Circular: July, 2013). E.2 Measures of market quality used Three measures are used for computin....
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....g market quality, size of market, volatility and liquidity. These measures are computed for the USD-INR futures contracts traded on the National Stock Exchange (NSE). In addition to these, the level of the USD-INR spot rate is also measured. Size measured by open interest (OI): This is the number of USDINR futures Ministry of Finance Department of Economic Affairs 63 IMPACT OF RESTRICTIONS ON CURRENCY DERIVATIVES ON MARKET QUALITY contracts that have not yet been settled. Participants have to set aside mar- gin capital for all their open positions. (Unit: USD billion per day) Realised volatility (RV): This is the annualised standard deviation of intra-day returns of the USD-INR futures contracts for a day. For this analysis, RV is computed using prices at five-minute intervals. (Unit: percentage) Liquidity measured by turnover: This is value of the total near-month USD- INR futures contracts traded on a single day. (Unit: USD billion per day) Liquidity measured by impact cost (IC): This is the extent to which a transac- tion of Rs. 1 million is inferior to the benchmark price of (bid+offer)/2. For this analysis, it is taken as the average of four values measured a....
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....t different times during the trading day. (Unit: percentage) E.3 Findings The following are the findings of the analysis: • There is a sharp drop in the open interest immediately after Event E3. (Fig- ure 1) • There is a pronounced surge in the realised volatility immediately after Event E3. (Figure 2) • There is a sharp decline in turnover immediately after Event E3. (Figure 3) • Extremely high values of impact cost, i.e., market illiquidity, are visible af- ter Event E3. Globally, an impact cost of more than a basis point, for a transaction of Rs.1 million, would be considered as indicative of a fairly illiquid market. In India, after Event E3, values of above a basis point are generally seen, and the worst values are greater than 100 basis points. (Fig- ure 4) • In case of all the three Events E1, E2 and E3, a statistically significant de- preciation of the rupee is observed after the event. If the objective of reg- ulatory action was to prevent currency depreciation, this was perhaps not achieved. Figure 5 E.4 Conclusion This analysis evaluates the facts around what happened in terms of market out- comes after the three events ....
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....of regulatory restrictions on the ETCD market. It does not assert causality, as the outcome may have been driven by other devel- opments. However, the time window of twenty days around the event enables observation of the visible impact of the events, especially of Event E3. It is ob- served that all measures of market quality, size, volatility and liquidity, worsen sharply after the Event E3. If the objective of these regulatory actions was to prevent further currency depreciation, it was not met. Ministry of Finance Department of Economic Affairs 64 IMPACT OF RESTRICTIONS ON CURRENCY DERIVATIVES ON MARKET QUALITY E.5 Graphs Figure 1 Open interest Each point in the figure below is the daily open interest of the near-month INR-USD future contracts from June 2011 to August 2013. The vertical lines mark the dates of policy interventions as described in Section E.1. E1 E2 E3 Jun 15 2011 Oct 03 2011 Jan 02 2012 Apr 03 2012 Jul 02 2012 Oct 01 2012 Jan 01 Apr 02 Jul 01 2013 2013 2013 Figure 2 Realised volatility Each point in the figure below is the daily realised volatility of the near-month INR-USD future contracts from June 2011 to August 2013. T....
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....he vertical lines mark the dates of policy interventions as described in Section E.1 E1 E2 E3 Jun 15 2011 Oct 03 2011 Jan 02 2012 Apr 03 Jul 02 2012 2012 Oct 01 2012 Jan 01 Apr 02 Jul 01 2013 2013 2013 Ministry of Finance Department of Economic Affairs 65 555 Ministry of Finance Impact cost of Rs 1mn (%) 0.0 0.5 1.0 1.5 2.0 USD Billion Z 3 456 0 1 IMPACT OF RESTRICTIONS ON CURRENCY DERIVATIVES ON MARKET QUALITY Figure 3 Turnover Each point in the figure below is the daily turnover of the near -month INR-USD future contracts from June 2011 to August 2013. The vertical lines mark the dates of policy interventions as described in Section E.1. E1 E2 Jun 15 2011 Oct 03 2011 Jan 02 2012 Apr 03 2012 Jul 02 2012 Oct 01 2012 Jan 01 2013 Apr 02 Jul 01 2013 2013 Figure 4 Impact cost Each point in the figure below is the daily impact cost of trading Rs 1 million on the near-month INR-USD future contracts from June 2011 to August 2013. The vertical lines mark the dates of policy interventions as described in Section E.1. E1 E2 Jun 15 2011 Oct 03 2011 Jan 02 2012 Apr 03 2012 Jul 02 Oct 01 Jan 01 2012 2012 2013 Apr....
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.... 02 2013 Jul 01 2013 Department of Economic Affairs 99 66 E3 E3 Ministry of Finance IMPACT OF RESTRICTIONS ON CURRENCY DERIVATIVES ON MARKET QUALITY Figure 5 Spot rate Each point in the figure below is the daily value of the reference rate for INR-USD from June 2011 to August 2013. The vertical lines mark the dates of policy interventions as described in Section E.1. E1 E2 Jun 15 2011 Oct 03 2011 Jan 02 2012 Apr 03 Jul 02 Oct 01 Jan 01 Apr 02 2012 2012 2012 2013 2013 Jul 01 2013 Department of Economic Affairs E3 67 20 References SEBI Circular: June (2014). "Participation of FPIs in the Currency Deriva- tives segment and Position limits for currency derivatives contracts." Tech- nical report, SEBI. URL http://www.sebi.gov.in/cms/sebi_data/ attachdocs/1403267985398.pdf. Abhijit Sen Committee Report (2008). "The expert committee to study the impact of futures trading on agricultural commodity prices." Technical report, Ministry of Consumer Affairs, Food and Public Distribution. Aggarwal N, Dutta S, Sharma A (2014). “The exchange rate exposure of Indian firms." Technical report, Finance Research Group, IGIDR, March 2014. URL http://....
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....www.ifrogs.org/Aggarwaletal2014_fxexposure.pdf. BIS (2013). "Triennial Central Bank Survey." Technical report, Bank of Interna- tional Settlements. URL http://www.bis.org/publ/rpfx13fx.pdf. Guru Committee Report (2001). “The expert committee on strengthening and developing agricultural marketing." Technical report, Department of Agricul- ture and Cooperation, Ministry of Agriculture. Handbook (2013). "Handbook on adoption of governance enhancing and non- legislative elements of the draft Indian Financial Code." Technical report, De- partment of Economic Affairs, Ministry of Finance. URL http://finmin. nic.in/fslrc/Handbook_GovEnhanc_fslrc.pdf. IOSCO (2010). "Report of the IOSCO taskforce on commodity fu- tures markets." Technical report, International Organization of Securities Commissions. URL http://www.iosco.org/library/pubdocs/pdf/ IOSCOPD 324-325.pdf. Percy Mistry Committee Report (2007). "Report of the High Powered Expert Committee on making Mumbai an international financial centre." Technical report, Ministry of Finance. Ray S, Malik N (2014). “Impact of transaction taxes on commodity derivatives trading in India.†ICRIER Working Paper no.....
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.... 272. RBI Circular: December (2011). "Risk Management and Inter Bank Deal- ings." Technical report, RBI. URL http://rbidocs.rbi.org.in/rdocs/ notification/PDFs/EAP58151211FL.pdf. RBI Circular: January (2012). “Risk Management and Inter-bank Dealings: Com- modities Hedging." Technical report, RBI. URL http://rbidocs.rbi.org. in/rdocs/notification/PDFs/68APDRM170112.pdf. RBI Circular: January (2014). "Risk Management and Inter bank Dealings: Hedging Facilities for Foreign Portfolio Investors (FPIs)." Technical re- port, RBI. URL http://rbidocs.rbi.org.in/rdocs/notification/ PDFS/AP28080914F.pdf. RBI Circular: July (2013). “Risk Management and Inter Bank Dealings." Technical report, RBI. URL http://rbidocs.rbi.org.in/rdocs/notification/ PDFs/07 APDCF080713.pdf. Ministry of Finance Department of Economic Affairs 68 88 REFERENCES RBI Circular: June (2014a). "Risk Management and Inter-bank Dealings: Guidelines relating to participation of Foreign Portfolio Investors (FPIs) in the Exchange Traded Currency Derivatives (ETCD) market." Technical re- port, RBI. URL http://rbidocs.rbi.org.in/rdocs/notification/ PDFs/148APD20062014.pdf. RBI Circular: June (2....
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....014b). "Risk Management and Inter-bank Dealings: Guide- lines relating to participation of Residents in the Exchange Traded Currency Derivatives (ETCD) market.†Technical report, RBI. URL http://rbidocs. rbi.org.in/rdocs/notification/PDFs/AP147200614F.pdf. RBI Circular: May (2012a). "Risk Management and Inter Bank Deal- ings." Technical report, RBI. URL http://rbidocs.rbi.org.in/rdocs/ notification/PDFs/CRINL100512C.pdf. RBI Circular: May (2012b). "Risk Management and Inter Bank Deal- ings." Technical report, RBI. URL http://rbidocs.rbi.org.in/rdocs/ notification/PDFs/CE9RM210512.pdf. Sane R, Thomas S (2013). "The real costs of credit constraints: evidence from micro-finance." Technical report, Finance Research Group, IGIDR, July, 2013. URL http://ifrogs.org/PDF/releases/Sane Thomas 2013_ creditConstraints.html. SEBI Circular: July (2013). "Revised Postion Limits for Exchange Traded Cur- rency Derivatives." Technical report, SEBI. URL http://www.sebi.gov. in/cms/sebi_data/attachdocs/1373297646169.pdf. SEBI Circular: March (2009). "Revised Postion Limits for Exchange Traded Cur- rency Derivatives." Technical report, SEBI. URL http://www.sebi.gov.in/ cms/sebi....
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...._data/attachdocs/1290070146147.pdf. Tayal R (2013). "Impact of restrictions on the trading of currency derivatives on market quality." Technical report, Finance Research Group, IGIDR, October, 2013. URL http://ifrogs.org/PDF/201309_ restrictions OnCurrency Derivatives.pdf. UNCTAD (2009). "Development impacts of commodity futures exchanges." Technical report, United Nations Conference on Trade and Development. UNCTAD and World Bank Joint Mission Report (1996). "Joint mission report: India: Managing price risk in India'd liberalized agriculture: Can futures mar- kets help?" Technical report, United Nations Conference on Trade and Devel- opment and The World Bank. REFERENCES Ministry of Finance Department of Economic Affairs 69 60<BR> News - Press release - PIB....