ARTICLE

INDIAN DERIVATIVE MARKETS: SOME POLICY ISSUES

-Anuradha Guru10
"Necessity is the mother of invention" said the Greek philosopher, Plato.

This, more than anywhere else, holds true for the financial markets, which are known to innovate to
keep pace with the growing needs and changing risk appetite of market participants. History of financial
markets is replete with examples of growth of markets giving rise to demands for new, different
instruments to enable investors to manage risks and markets innovating to satisfy these demands. As
an example, the innovation and growth of derivative instruments was the result of satisfaction of
demand of market players for a means to hedge price risk of holding an inventory of commodities.
While they first emerged as hedging devices against fluctuations in commodity prices and commoditylinked derivatives and were the sole forms of such products for a long time, they were replicated for
financial instruments as well in the post-1970 period due to growing instability in the financial markets.
In the recent years, the market for financial derivatives has grown both in terms of variety of instruments
available, their complexity and turnover.
As per the Futures Industry Association (FIA) Annual Volume Survey, more than 15 billion futures and
options contracts were traded during 2007 on the 54 exchanges that report to the FIA, an increase of
28% from the previous year. The growth rates were 19% in 2006, 12% in 2005, and 9% in 2004.
As regards the position of derivatives trading in India, among the top derivatives exchanges worldwide,
the National Stock Exchange of India (NSE) ranked 9th in 2007 in terms of futures and options volume
with 379 mn contracts being traded in 2007 (Source: FIA). In terms of trading volumes in single stock
futures, while the NSE was ranked first (1st) in terms on number of contracts traded in 2006, it has
shifted to second position as the Johannesburg Stock Exchange (JSE) overtook NSE with a 265.49
million contracts traded in 2007 at the JSE as against 179.33 contracts on the NSE11.
The factors that have been driving the growth of financial derivatives worldwide are technological
developments leading to development of more sophisticated risk management tools; increased volatility
in asset prices in financial markets; increased integration of national financial markets with international
markets and the inherent characteristic of the derivatives markets to be able to optimally combine the
risks and returns over a large number of financial assets. These financial instruments are becoming an
increasingly important vehicle for unbundling risks as they enhance the ability to differentiate risk
and allocate it to those investors most able and willing to take it.
However, on their journey of innovation, derivatives have not been free from controversies. They have
often been held to be too complex to comprehend. The leverage that these products provide to investors
raises concern. Recently, the present global financial crisis is being attributed to the housing mortgages
being repackaged and sold as collateralised debt obligations and other exotic derivative products to
financial institutions, pension funds and individuals. Policy markers around the world are now having

10

The author is with the NSE. Views are personal.

Source: World Federation of Exchanges: Annual Report and statistics, 2007

11

11
http://www.nseindia.com

a relook as the problems being posed by derivatives viz. lack of homogeneous rules and accounting
standards; the excessive freedom allowed to market players to innovate and the lack of complete
statistics for exchange-traded and OTC transactions. Leaders are talking about the need for more
transparency and accountability in the functioning of derivative markets.
While this exercise is underway, the aim of this paper is to present the historical perspective in
which derivatives have developed in India and present certain issues which have been widely
debated in the context of these markets in India, while also presenting the international context
of the debates.
The regulatory framework for Indian derivative markets has evolved overtime starting with promulgation
of the Securities Laws (Amendment) Ordinance, 1995 which withdrew the prohibition on options in
securities by repealing section 20 of the Securities Contracts (Regulation) at, 1956 [SC(R)A]. There
after, the Securities and Exchange Board of India (SEBI) appointed committee under the chairmanship
of Dr. L. C. Gupta in November 1996, which recommended an appropriate regulatory framework for
derivatives trading in India. In March 1998, the L. C. Gupta Committee (LCGC) submitted its report
recommending the introduction of derivatives markets in a phased manner beginning with the
introduction of index futures.
The Committee noted that:
"The evolution of markets in commodities and financial assets may be viewed as a worldwide long-term
historical process. In this process, the emergence of futures has been recognised in economic literature as
a financial development of considerable significance."
It further opined that:
"financial futures have quickly spread to an increasing number of developed and developing countries.
They are recognized as the best and most cost-efficient way of meeting the felt need for risk-hedging in
certain types of commercial and financial operations. Countries not providing such globally accepted riskhedging facilities are disadvantaged in today's rapidly integrating global economy."
Thus, the decision to commence with derivatives trading was taken and another committee appointed
by SEBI in June 1998, under Prof. J.R. Varma, to recommend measures for risk containment for these
markets. Derivatives trading commenced in June 2000, after necessary legislative amendments12 and
SEBI approval, on the NSE and BSE. Trading first commenced in Index futures contracts in June
2000, followed by index options in June 2001, options in individual stocks in July 2001 and futures in
single stock derivatives in November 2001.
The LCGC was cautious in its approach towards launching of equity derivatives in India. It favored:
" the introduction of equity derivatives in a phased manner so that the complex types are introduced
after the market participants have acquired some degree of comfort and familiarity with the simpler
types. This would be desirable from the regulatory angle too."
India's experience with derivative products has been very encouraging and we quickly emerged as one
of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives.
The turnover in the derivatives segment of the NSE soon overtook the turnover in the capital markets
segment of the exchange. As per the latest data for the period April 08 to Nov 08, the turnover in the

12

The Securities Contracts (Regulations) Act, 1956 was suitably amended to define "derivatives" and classify them
as "securities" under the Act.

12
http://www.nseindia.com

derivatives segment of the NSE was around 3.8 times that on its capital markets segment. This speaks
aloud on the way derivative instruments have been accepted by the market participants in India.
Overtime, the number of contracts available for trading in the derivatives segment of the exchanges
has increased. On the NSE, as at end November 2008, 42,218 contracts were available for trading.
To expand the universe of risk hedging products available to the market, Interest rate futures were
launched in June, 2003. However, the product did not pick up as the design of the product had some
flaws and also banks were not permitted to take trading positions in these instruments. The product
was now been reintroduced and RBI has permitted banks to take trading positions in October, 2008.
SEBI set up a Derivatives Market Review Committee, in March 2007, to look into the developments in
derivatives market in India and also suggest future possibilities and course of action. The Committee,
in December 2007, recommended introduction of certain new derivative instruments based on global
experience and the perceived appetite for new products in the Indian markets. These included mini
contract in equity indices; long term option contracts, options on futures; exchange traded currency
futures and Exchange-traded Products Involving Different Strategies. Based on these recommendations
the new products that have been launched by the NSE in 2008 are the mini Nifty contracts, long
tenure options and exchange traded currency futures.
While we are yet to see how these derivative instruments are received by the market, there are still
many more milestones to cross in terms of expanding the universe of derivative products available to
the market participants. Let us just take a look at what kind of asset classes are covered by derivative
contracts globally and what is the position in India.
As seen from the figure below, in the rest of the world, new and innovative derivative products are
being traded. These include, weather derivatives, Volume futures/options, Energy derivatives, Credit
derivatives etc.
Going ahead, we need to think about expanding the universe of available hedging instruments in the
form of derivatives. The regulators in India need to encourage financial innovation. The LCGC also
recognized that:
"While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which
is the source of all economic progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology."
REST OF THE WORLD
INDIA
-Index futures
-Index options
-Stock futures
-Stock options
-Commodity futures
-Interest rate futures
-Rupee Currency

-Weather derivatives
-Volume futures and options
-Credit derivatives
-Binary credit derivatives
-Freight derivatives
-Inflation derivatives

One important product that has been in the offing for a long time now, but has not been introduced as
yet is the credit derivatives. In the year 2003 the RBI issued the first draft on guidelines on credit

13
http://www.nseindia.com

derivatives trading. It released another draft guideline in May, 2007. Between March 2003 and
May 2007, four years have lapsed and the credit derivatives market has not yet started functioning.
Various apprehensions have been expressed about the preparedness of Indian markets for this product
in terms of risk management infrastructure and comprehension of the product itself. These
apprehensions of the market regulators have been aggravated further in the light of the present global
financial crisis as pointed out earlier in the article. Thus, this product has for the present been kept on
hold for the Indian markets.
Besides the issue of expanding the universe of derivative instruments available in the Indian markets,
two important policy issues that confront the markets are the choice between cash and physical
settlement and the choice between exchange traded and OTC derivative markets. These are elaborated
below
Cash vs Physical settlement
There has been much controversy about the two modes of settlement that are available for derivative
contracts, viz. cash and physical settlement, comparing the two on the basis of their vulnerability to
speculation and manipulation. Physical settlement, it is argued, provides the link to the real markets
of the underlying securities. However it is susceptible to distortions such as "short squeezes"13 . Cash
settlement, on the other hand, provides the benefits of avoiding the problem of delivery costs and
lowering the effectiveness of market manipulations such as cornering and squeezing.
Presently, all derivative contracts in India are cash settled. Looking at the debate on cash vs physical
settlement of derivatives in India, we find that the LCGC Report took it for granted that physical
settlement would be used for derivative contracts on individual stocks. It noted that:
"In the case of individual stocks, the positions which remain outstanding on the expiration date will
have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the
cash market prices have to converge on the expiration date. Since Index futures do not represent a
physically deliverable asset, they are cash settled all over the world on the premise that the index value
is derived from the cash market. This, of course, implies that the cash market is functioning in
a reasonably sound manner and the index values based on it can be safely accepted as the
settlement price.
However, when single stock derivatives were introduced in India, it was decided to use cash settlement
to begin with because the exchanges did not then have the software, legal framework and administrative
infrastructure for physical settlement. It was proposed that cash settlement would be replaced by
physical settlement as the exchanges developed the capabilities to achieve physical settlement efficiently.
In April 2002, SEBI's Advisory Committee on Derivatives (ACD) proposed a broad framework for physical
settlement presenting the risks and benefits of physical settlements along with possible risk containment
measures. The ACD noted the following as the principal issues involved in physical settlement:

In the absence of a vibrant mechanism for securities lending and borrowing, physical settlement
of stock specific derivative contracts, especially stock options, may raise concerns on the
possibility of a short squeeze.

13

A situation where some economic agents adopt a long position on the futures market which is larger than the
stock of physical deliverable in existence, causing the spot price to rise and giving profits to the manipulator.

14
http://www.nseindia.com

Globally, cash settlement is cheaper than physical settlement, but the economics may be
less clear cut in India where the modernization of the payment system has lagged that of the
securities settlement system.

Under the existing procedure of cash settlement, hedgers and arbitrageurs incur overnight
price risk for liquidating one leg of the transaction in the cash markets. A hedger (who by
definition has a position in the underlying) would have to liquidate that position in the cash
market and then bears the risk that the price realized in the cash market would differ from
the settlement price used for cash settlement in the derivative markets. The same argument
applies to arbitrageurs. Speculators on the other hand would find cash settlement beneficial
since they do not (by definition) have an offsetting cash market position and cash settlement
saves them the burden of operating in two markets. Physical settlement of derivative contract
helps hedgers and arbitragers avoid basis risk while imposing some additional costs on
speculators.

The committee held the view that the regulatory regime should be more in tune with the requirements
of hedgers and arbitrageurs than the needs of speculators. For this reason, it recommended physical
settlement which protects hedgers and arbitrageurs from basis risk in the settlement process. At the
same time, the Committee recognized the concerns regarding short squeezes in physical settlement
and recommended certain measures to reduce the risk of short squeeze. As regards the mechanism of
physical settlement the Committee recommended a model where the cash market clearing corporation
is used to settle derivatives and the mechanism of physical settlement is such that at no point in time
are trades on the derivative segment commingled with trades on cash market.
SEBI approved of this recommendation and was of the view that it would be desirable to have a vibrant
system of margin-trading and securities lending and borrowing in the cash market, before allowing
physical settlement. Both the schemes were permitted by SEBI in March, 2004. The margin-trading
scheme was not successful as the market did not perceive the scheme to be attractive or efficient. The
ACD again deliberated on this issue and reiterated that physical settlement is dependent on a vibrant
securities lending and borrowing mechanism.
It is being debated that since a full-fledged securities and lending mechanism is now in place and short
selling by all market participants has been permitted (since April 21, 2008), it may now also be the time
to move to physical settlement of derivative contracts.
In this context, it would be instructive to ask if the physical settlement is an end in itself or a means to
something. If the objective is the efficient and liquid market where futures price converges with the
spot price on expiration, then cash settlement is equally effective, if not more. We look at some evidence
on the process of price discovery and market manipulation under the physical and cash settlement
system.
An "efficient" price discovery process happens when the private information embodied in the future
market participants seamlessly percolates to the spot market. Presented here are certain empirical
studies on efficiency of cash vis--vis physically settled derivative contracts. While the first two studies
deal with commodity markets, the implications would be even more pertinent in markets with financial
underlyings.
-Nabil Chaherli and Robert Hauser (1995) analyze the delivery system in the Chicago Board of Trade
corn and soybean contracts, alternative physical delivery systems, and cash settlement systems.

15
http://www.nseindia.com

A theoretical model of futures pricing with delivery option is used to simulate futures prices with
different terms of construct cash indices. Results suggest that cash settlement provides slightly higher
levels of hedging effectiveness than any type of multiple physical deliveries.
- Donald Lien and Yiu Kuen Tse (2002) investigate the effects of the switch from physical delivery to
cash settlement on the behavior of the cash and futures prices of the feeder cattle contract traded on
the Chicago Mercantile Exchange. The results show the following:

Volatility of the futures prices (but not the cash prices) declined after physical delivery was
replaced by cash settlement.

In terms of futures hedging, cash settlement led to smaller and more stable hedge ratios.

The variance of the hedged portfolio also decreased substantially.

The evidence suggests that cash settlement is beneficial to the feeder cattle futures market.
- Donald Lien and Li Yang (2004) look at the experience of Australian stock exchange with the introduction
of physical delivery. The study investigates the effects of the settlement method change on Australian
individual stock and its futures markets. Specifically, it examines whether return and volatility of each
market, correlation between the two markets, basis behavior, and hedging performance of futures
markets differ across cash settlement period and physical delivery period. The study concludes that
after the switch from cash settlement to physical delivery, the futures market, the spot market, and
the basis all become more volatile.
In conclusion, there is, thus, no fundamental difference on price discovery and it is always possible to
obtain convergence of futures price to the spot price on expiration date, both under physical as well as
cash settlement, because this convergence depends upon arbitrage and it is perfectly feasible to do
arbitrage under cash settlement.
Prof Varma points out that according to Finance theory, the only difference between receiving the
underlying and receiving its price (i.e physical and cash settlement) is the transaction cost involved.14
To convert the price into the underlying or the other way around requires one transaction in the cash
market - nothing more and nothing less. Even these costs do not apply to most trades because they are
squared off before expiry. The choice of settlement mode can, according to him, therefore, be safely left
to market forces. But if the regulator chooses to intervene, it should be on the side of physical settlement
because it imposes lower transaction costs on hedgers and arbitrageurs at the cost of higher transaction
costs on speculators.
OTC vs exchange traded derivatives
Derivatives trading can be organized in two ways. The first way is through bi-lateral agreement between
counterparties, called the `over the counter' or `OTC derivatives' transactions. Another way is through
the anonymous order matching platform of the stock exchange. Exchange-traded contracts are
standardized, with regard to maturity date, contract size and delivery terms, whereas OTC contracts
are custom-tailored to the client's needs. Worldwide there is has been a phenomenal increase in OTC
transactions, as indicated from the table below:

14

http://www.iimahd.ernet.in/~jrvarma/papers/BS-19Jan2004.pdf

16
http://www.nseindia.com

Global Exchange traded derivatives volume by category

(in USD millions)
GLOBAL
2007
2006
Equity Indices
5616.82
4453.95
Interest Rate
3740.88
3193.44
Individual Equities
4091.92
2876.49
Energies
496.41
385.97
Agricultural
645.64
489.03
Metals
256.07
218.68
Currency
334.71
240.05
Others
4.23
4.36
Total Volume
15186.67
11862.21

Percentage change
26.1
17.14
42.25
28.61
32.02
17.09
39.43
-2.98
28.03

Source: Futures Industry Magazine, March/April 2008.

The growth in this market has been led by the innovations happening in structured finance and other
customized derivatives products. These innovations are driven by the investor's demands and the
competition among the institutional brokers to cater to these demands.
Some of the advantages of OTC contracts are:

Buyers and Sellers can negotiate the contracts as per their respective needs to come with
customized products.
Transaction costs can be reduced. The fees like exchange fees, clearing fees can be eliminated.
OTC derivatives market can be used for executing bulk orders without the risk of market
impact.

Table below presents the derivative transactions on organized exchanges vis--vis those happening in
the OTC markets. As is evident from the data, while both exchange traded and OTC derivative
transactions are increasing, the rate of growth of amounts outstanding of exchange traded derivative
instruments was 14% over Dec-06 to Dec-07 vis--vis 43.5% growth in OTC derivations over the same
period. Over the period Dec-07 to June-08, the rate of growth of outstanding OTC derivative transactions
was 15% as against 5% growth in amounts outstanding on exchange traded derivative transactions.

Derivative financial
instruments traded on
organised exchanges
(amounts outstanding)

Notional amounts of
OTC derivatives
outstanding

Products
Interest rate futures
Currency futures
Equity Index futures
Interest rate options
Currency options
Equity Index options
Total
Foreign exchange contracts
Interest rate contracts
Equity linked contracts
Commodity contracts
Credit default swaps
others
Total

Dec-06
24,476
161
1,045
38,116
79
5,529
69,406
40,271
2,91,582
7,488
7,115
28,650
39,740
4,14,846

Dec-07
26,770
159
1,132
44,282
133
6,625
79,101
56,238
3,93,138
8,469
8,455
57,894
71,146
5,95,340

Jun-08
26,874
176
1,584
46,905
191
7,088
82,818
62,983
4,58,304
10,177
13,229
57,325
81,708
6,83,726

Source: BIS Quarterly review, December, 2008.

17
http://www.nseindia.com

Though OTC transactions have certain benefits as mentioned above, they are generally held to be faced
with problems of inefficient price discovery and large counterparty risk as they are privately negotiated,
devoid of novation which a clearing corporation offers. A recent IMF working paper15 attempts to quantify
counterparty risk that may stem from the OTC derivatives markets. The risk is measured by losses
that may result via the OTC derivative contracts to the financial system from the default (or fail) of one
or more banks or broker dealers. It finds that considering that the notional value of all categories of the
OTC contracts reached almost $600 trillion at the end of December 2007, the failure of a single major
financial institution could result in losses to the OTC derivatives market of $300-$400 billion. The
paper argues that since such a failure would likely cause cascading failures of other institutions, the
total global financial system losses could exceed $1,500 billion.
However, there is another aspect of this debate which argues that we are presently witnessing an
increasingly diminishing boundaries between the exchange traded and OTC derivatives markets. We
note the following:
a.

Exchange-traded contracts are generally thought of as having been standardized (with regard
to maturity date, contract size and delivery terms), whereas OTC contracts are customtailored to the client's needs. Some exchanges, however, have introduced derivative instruments
that can provide a significant degree of customization16. A notable example is the "Flex"
option, which was introduced by the Chicago Board of Options Exchange (CBOE) in February
1993. Flex options allow investors to choose strike prices, expiration date and style. The
Chicago Board of Trade (CBOT) has introduced "Flexible Treasury Option" written on U.S.
Treasury bonds and bills which allows for investors' choice of exercise price, expiration date
and style. Such products are now also being offered by the Toronto Stock Exchange, the
Philadelphia Stock Exchange, the American Stock Exchange and the London International
Financial Futures Exchange etc.

Also, in practice, OTC markets may follow certain simplifying market conventions that provide a certain
degree of standardization. For example, most interest rate swaps in Canada are fairly standardized,
typically involving the exchange of cash flows on a contract's notional value based on 1-month or
3-month bankers' acceptances (floating interest rate) for 2- to 5-year Government of Canada bonds
(fixed rate).
b.

The general perception about OTC markets is that they have high counterparty risk. However,
the Bank for International Settlement's Committee on Payment and Settlement Systems
(CPSS), in a report on "New developments in clearing and settlement arrangements for OTC
derivatives", published in March 2007, based on a survey of 35 large OTC dealers, has interalia, noted the following:
i.

Expanded use of collateral now significantly mitigates counterparty credit risks, and the
legal and operational risks associated with reliance on collateral have been reduced by
changes in national law and enhancements to dealers' collateral management systems.

ii.

The use of Central Counterparties (CCPs) has expanded in financial markets generally,
spurred by increasing use of electronic trading systems. Some CCPs have also developed

15

IMF Working Paper: Counterparty Risk in the Over-The-Counter Derivatives Market by Miguel A. Segoviano and
Manmohan Singh, November 2008.
16
The Microstructure of Financial Derivatives Markets: Exchange-Traded versus Over-the-Counter by Brenda
Gonzlez-Hermosillo, Bank of Canada (March 1994)

18
http://www.nseindia.com

services that enable products traded over the counter to be submitted for clearing. In
most instances, the OTC products are converted into equivalent exchange-traded
contracts to facilitate clearing and to allow for offsetting with exchange-traded products.
Examples include:
- Bclear, an exchange service launched by EuroNext.Liffe at the end of 2005, which brings equity
derivatives transactions initially conducted OTC to LCH.Clearnet for trade confirmation, administration
and clearing. The original transaction is replaced by an exchange contract through novation;
- the OTC Trade Entry Facility provided by Eurex Clearing AG;
- Clearing 360, a similar service offered by the Chicago Mercantile Exchange (CME) for OTC interest
rate derivatives. In operation since April 2006, Clearing 360 takes a bilaterally negotiated OTC swap
trade and converts it into a strip of futures contracts, which are then submitted to CME for clearing;
- Converge, a service launched in October 2006 by the Canadian Derivatives Clearing Corporation, a
wholly owned subsidiary of the Montreal Exchange. This service clears OTC equity options; and
- the New York Mercantile Exchange's ClearPort facility, which transforms OTC natural gas and other
energy derivatives into exchange-traded and cleared futures.
c.

A trade information warehouse has been created by the Depository Trust & Clearing
Corporation (DTCC) and launched in November 2006. The Trade Information Warehouse
("Warehouse"), as the market's central registry and industry-recognized post-confirm
infrastructure for credit derivatives, is optimally equipped to support any and all CCPs that
are established in the CDS market. Virtually all dealers and buy-side participants along with
15 third-party service providers in the global CDS market are already linked to the Warehouse
and utilize its functionality.

The position in India

Economic entities in India currently have a menu of OTC products. In respect of forex derivatives
involving rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee
swap instruments and currency options - both cross currency as well as foreign currency-rupee. For
derivatives involving only foreign currency, a range of products such as IRS, FRAs, option are allowed.
The rupee interest rate derivatives presently permissible are Forward Rate Agreements (FRA), Interest
Rate Swaps (IRS) and Interest Rate Futures (IRF). Table below indicates the activity in the OTC markets
in India:
OTC derivatives turnover in April 2007
Daily averages, in mn of USD
OTC foreign

Outward forwards

6,299

exchange

Foreign exchange swaps

13,437

derivatives

Currency swaps

479

Options

3,800

OTC single currency

Forward rate agreements

interest rate derivatives

Swaps

3,395

Options

Total

27,410

Source: BIS Triennial Central Bank Survey of foreign exchange and derivatives markets activity, 2007.

19
http://www.nseindia.com

The corresponding activity on the derivatives segment of the largest derivatives exchange, the National
Stock exchange, in the month of April 2007 was Rs 30,8143 mn (or USD 7463 mn17) of average daily
turnover.
Thus, in line with international trend, the OTC derivatives markets in India are far larger than the
exchange traded market for derivatives.
The debate on choice between the two ways of trading in derivative, viz. on exchange and OTC, in India
is on the same lines as the international debate. It is recognized that OTC trading, while permitting
unlimited flexibility in the contract, suffers from non-transparency, inefficient price discovery and
generally involves counterparty risk. However, there are some benefits of OTC markets, as pointed out
by Prof J.R.Varma, who argues for the creation of an OTC equity derivative market in India18. He is of
the view that competition between OTC markets and exchanges forces each market to lower costs and
to adopt the best practices of the other market. He further holds that standardized and highly liquid
contracts are best traded in organized exchanges because of the enhanced transparency and lower
systemic risk. However new contracts are often best incubated in OTC markets until they achieve a
critical mass of liquidity and widespread participation at which point they can be moved to the exchange
traded format. Long dated equity options are today best incubated in OTC markets.
On the other hand, on the role of exchange-traded vs OTC derivatives, the recent report of Government
appointed High Powered Expert Committee on Making Mumbai an International Financial Centre has
stressed on a greater role for exchange-traded derivatives in an Indian International Financial Center,
inter-alia, for the following reasons:
-

The present OTC market in India largely trades plain vanilla products for which exchange
traded platform is a better option as it provides transparency and liquidity at no cost in
flexibility.

In an environment where India's regulatory and supervisory capacity in the derivatives markets
in still nascent but evolving, exchange traded markets are easier to regulate than the opaque
OTC markets which make greater demand upon regulation and governance.

Exchange traded markets fit better with non-institutional customers who are not able to
access the telephone network through which OTC trading takes place.

Exchange traded derivatives trading plays to India's strengths in running exchange institutions.
Our two national exchanges (BSE and NSE) and clearing corporations (NSCCL and CCIL) are
a strong set of institutions who can compete in the global market for exchange traded
derivatives.

The report, on this issue, concludes that India needs both exchange traded derivatives and OTC
derivatives. However, based on the above arguments, it is desirable to lay special focus on obtaining
world-class liquidity on the exchange platform, after which OTC market can spring up based on utilization
of the prices and liquidity produced on this platform.

17
18

Converted at the 2007 calendar year annual average exchange rate, published by the RBI, of IUSD=Rs. 41.29.
http://www.iimahd.ernet.in/~jrvarma/papers/OTC-Derivatives-Bus-Std-online-14 Nov. 07.pdf

20
http://www.nseindia.com

In conclusion, one has seen a significant growth of OTC derivatives market world over. Internationally,
the problems of technology solutions and risk management are increasingly being addressed by new
developments in the market like introduction of electronic trading and confirmation systems, CCP
clearing the trades etc. With these developments happening, analysts have argued that it is actually
leading to unification of the organized exchange market and the OTC market. There are other sets of
analysts who feel both the exchange and OTC derivatives market will co-exist as they cater to needs of
different user.
However, there is a renewed debate on the level of transparency and counterparty risk in the OTC
markets kindled by the sub prime mortgage crisis in the US and the need to regulate OTC transactions
effectively, as also mentioned in the introduction of this article. This throws up important issues
which, at best, may need to be handled separately.
For the present, one could say that these markets, viz. exchange traded and OTC, are two competing
market and each have unique characteristics.
References
Nabil Chaherli and Robert Hauser, Delivery Systems versus Cash Settlement in Corn and Soybean
Futures Contracts, SSRN working paper. February 1995.
Donald Lien and Yiu Kuen Tse, Physical delivery versus cash settlement: an empirical study on the
feeder cattle contract, Journal of Empirical Finance, November 2002.
Donald Lien and Li Yang, Alternative settlement methods and Australian individual share futures
contracts, Journal of International Financial Markets, Institutions and Money December 2004.

21
http://www.nseindia.com