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Institute of Financial Markets of Pakistan (IFMP)
Position Paper 1: Derivatives in Pakistan: Challenges, Opportunities and Recommendations
Institute of Financial Markets of Pakistan

Position Paper No. 1
2017
Derivatives in Pakistan: Challenges, Opportunities and Recommendations
Dr. Hameedah Sayani

Hameedah.Sayani@ifmp.org.pk
The author is based in Toronto, Canada and is currently associated with the Institute of Financial Markets of
Pakistan (IFMP) as a Non-resident Research Consultant
2
Acknowledgements
Special thanks for invaluable and unwavering support to the Institute by:
Mr. Zafar ul Haq Hijazi

Chairman
Securities and Exchange Commission of Pakistan
The author also acknowledges the valuable input provided by the following individuals:
Mr. Muhammad Ali Khan

Chief Executive Officer
Institute of Financial Markets of Pakistan
Mr. Amjad Khan

Chief Operating Officer
Pakistan Mercantile Exchange
Mr. Nauman Lakhani

Head of Marketing, Business Development & Customer Support Services
Mr. Sani-e-Mehmood Khan

GM Product Development
Pakistan Stock Exchange
Mr. Naveed Akber Raja

Manager New Products
Mr. Fahad Fahim

Head of Middle Office & Operational Risk
Pak Brunei Investment Company Limited
The author also acknowledges the support of following entities for the provision of data:
Securities and Exchange Commission of Pakistan

State Bank of Pakistan
3
Synopsis
This paper aims to identify the challenges that impede the development and growth of
organized financial and commodities derivatives markets in Pakistan. It also discusses the
future outlook of the country and the financial markets, and provides relevant
recommendations. The paper elaborates on various kinds of derivatives and their
characteristics, discusses the functions of and the users of derivatives markets, offers a
historical overview and the current status of the global derivatives markets, provides a
brief history of derivatives trading in Pakistan and its current status, and undertakes a
comparison with relatively active regional derivatives markets. The paper also discusses
the determinants of success of derivatives markets as presented in the literature. It then
highlights the supply and demand side challenges, and finally presents some
recommendations for the development of derivatives markets with respect to the dynamic
economic and financial context of Pakistan.
1. Derivatives and their Characteristics

The International Accounting Standard (IAS) 391 defines a derivative as a financial
instrument with three characteristics. First, it derives its value from a specified interest
rate, security price, commodity price, foreign exchange rate, index of prices or rates, and a
credit rating, credit index, or similar variable commonly referred to as ‘underlying’. Second,
it requires zero or marginal investment relative to other types of contracts that are also
affected by changes in market conditions in the same manner. Lastly, it is settled at a future
date.
1
IAS 39 will be replaced by IFRS 9 and will be in effect after 1 January 2018 (IFRS, 2016).
4
Derivatives trade on organized exchanges as well as in Over-the-Counter (OTC) markets

and can be classified into four categories, namely forwards, futures, options, and swaps.
While forward and future contracts bind two parties to deliver or take delivery of an
underlying asset at a pre-determined price and date, options provide the buyer a choice to
buy or sell a particular asset on or before the expiry date2 at a specific price. Under a swap
contract, two counterparties agree to exchange sequences of cash flows for a set period of
time. Table 1 summarizes the characteristics of the above-mentioned derivatives.
Table 1: Derivatives and their Characteristics
Forwards Futures Options Swaps
Trading Organized Organized
OTC OTC1
Platform Exchanges Exchanges/OTC
Financial/ Financial Financial/ Interest rates/
Underlying
Commodity /Commodity Commodity Currency
Standardised or
Structure Customized Standardized Customized
Customised
Highly regulated or
Regulation Unregulated2 Highly regulated Unregulated2
Unregulated
Marked to Market Marked to Market Periodic sash flow
No periodic cash
Cash flows Margin Margin based on notional
flows
requirement requirement3 principal
Margins
Guaranteed by Clearing House
Guaranteed by
Performance creditworthiness Margins or
creditworthiness of
Guarantee of the parties Clearing House Guaranteed by
the parties involved
involved creditworthiness of
the parties involved
Physical / Cash Physical / Cash Physical or Cash
Settlement Cash settlement 4
Settlement Settlement Settlement
High or Low
Low
High Counter party or High
Default risk Exchange
Counter party Exchange Counter party
guaranteed
guaranteed
Retail Investors / Retail Investors
Users Institutions Institutions
Institutions and/or Institutions
Liquidity Low High High Low
Transaction
High Low Low High
costs 5
Notes: 1A small number of swaps can also be originated on large and mature exchanges
2Fall’s under private contract law.
3 Applicable to the seller of options in exchange traded transactions. The buyer of the
option pays a premium for the right.

4It is possible to exit the swap contract before expiry through various arrangements.
5Transaction costs include monetary and other costs such as time and effort to look for
a suitable counterparty.
While derivatives are used widely for risk management, they are still exposed to some
systematic and unsystematic risks, such as credit risk, market risk, liquidity risk,
operational risk, and legal risk.
2
European options can only be exercised on a particular pre-determined date. On the other hand, American
options can be exercised even before the expiry date.
5
2. Functions and Users of Derivatives Markets

The primary function of a derivatives market is to provide a platform to institutions and
individuals to manage risks associated with cross-border business transactions, fluctuating
interest rates, and prices of financial assets and commodities. These markets facilitate price
discovery of the underlying, provide liquidity in the markets, and enable investors to
benefit from leverage. These markets are not time-bound and offer multiple connectivity
options.
The investors in derivatives markets can broadly be classified into retail and institutional
investors. Table 2 provides details of the derivative products that are available to these
investors on organized exchanges and OTC markets.
Table 2: Users of Derivatives
Users Exchange Based Over-the-Counter
Retail Investors  Equity-linked derivatives (Exchange N/A
Traded Funds, Equity-based Options)
 Fixed Income Derivatives
 Equity-linked Derivatives
 Fixed Income Derivatives
Institutional/Wholesale/  Commodity Derivatives
Professional Investors  Equity-linked Derivatives
 Foreign Exchange
 Commodity Derivatives
Derivatives
 Credit Derivatives
Source: Deutsche Börse AG (2008)
Both retailers and institutional investors enter into derivative contracts with different
purposes and can be classified under the following categories:
i. Hedgers: Those investors who wish to mitigate the risk of price movements of a
particular underlying financial or real asset, commodity, or interest rates. Hedgers are
mostly producers of agro-commodities, industries, importers & exporters financial
institutions and other organizations who enter into derivatives transactions to fix the
future prices for underlying assets that are vital to their business operations. Besides
taking positions in relevant derivatives contracts mostly on the OTC markets,
financial institutions also provide hedging facilities to hedgers and earn profits
through spreads.
ii. Speculators: Such investors bet on the future prices of the assets. They trade in the
market with an anticipation of earning abnormal profits depending on the direction
of price change of the underlying. This group of investors uses either fundamental or
technical analysis to decide on positions to take in the market.
6
iii. Arbitrageurs: These investors earn profits by exploiting market imperfections. Such
transactions facilitate price discovery and reduce anomalies in the markets as market
forces act to bring the prices of the same assets at par in different markets.
The co-existence of all the above investors is critical for maintaining liquidity in the
derivatives markets and to derive benefits from it. Some additional factors such as the size
of the spot market, characteristics of the underlying assets, liquidity, and hedging
effectiveness are important for an active derivatives market. These factors are discussed in
detail in section 6.
3. Overview of Global Derivatives Markets

According to the Futures Industry Association (2016), there are nearly 80 derivatives
exchanges3 in the world and the growth and popularity of the derivatives was led by Asian
markets in 2015 (Figure 1). Figure 2 presents the percentage contribution of various
exchange-traded derivatives globally. Less than 20% of the overall notional amount
outstanding is traded on exchanges (Bank for International Settlements, 2016 a, b). Figures
3 and 4 provide details of the notional amount of global exchange traded and OTC
derivatives. The transactions cost of trading on organized exchanges is one-eighth of the
cost of OTC trading (Deutsche Börse AG, 2008).
Figure 1: Regional Contribution in Global Derivatives Trading

Latin America, 5.9% Other*, 2.7%
Europe, 19.3%
Asia-Pacific, 39.2%
North America,
33.1%
Source: Futures Industry Association (2016)
Notes: *Includes Greece, Israel, South Africa and Turkey
Figure 2: Composition of Exchange Traded Derivatives Market
3Someexchanges are owned and operated by a single group. For example, the Intercontinental Exchange
owns and operates six derivatives indices altogether.
7
Non-Precious Others*, 3.3% Precious Metals,

Metals, 5.2% 1.3%
Energy, 5.7%
Equity Index, 33.7%
Agriculture, 6.6%
Currency, 11.2% Interest Rates, Individual Equity,

13.1% 19.9%

Notes: *Contracts based on commodity indices, credit, fertilizer, housing, inflation, lumber,
plastics and weather
The interest in equity indices based derivatives is evident, as they comprise more than 30%
of the derivatives traded on the exchanges. It is not surprising, as these are most suitable
for passive investors and enable investors to track the performance of a particular index.
Figure 3: Exchange-traded Futures and Options by Location

Open Interest (Notional Amount in Billions of US dollars)
Dec Dec Mar Dec Dec Mar
-14 -15 -16 -14 -15 -16
Options
Futures
0 10,000 20,000 30,000 40,000 50,000
6,000 Average Daily Turnover
4,000
2,000
0
Futures Options
2014 2015 Mar-16 2014 2015 Mar-16
North America Europe Asia and Pacific Other Markets
Source: Bank for International Settlements (2016a)
Figure 4: Global OTC Derivatives Market
8
600,000 Notional Amounts Outstanding (Billions of US dollars)

500,000
400,000
300,000
200,000
100,000
0
Foreign exchange Interest rate Equity-linked Commodity Credit default Unallocated
contracts contracts contracts contracts swaps
Gross Market Value

20,000
10,000
0
Foreign exchange Interest rate Equity-linked Commodity Credit default Unallocated
contracts contracts contracts contracts swaps
H1 2014 H2 2014 H1 2015 H2 2015
Source: Bank for International Settlements (2016b)
The daily turnover in emerging markets increased four times during 2000-2010 and stood
at more than 6% of emerging markets’ GDP in 2010. Moreover, the volume traded on the
OTC and organized exchanges was almost equal, with foreign exchange derivatives being
the most popular category and interest rates derivatives being the least popular.
Heightened foreign trade in products and services has resulted in an increasingly global
nature of derivatives transactions. Lastly, a positive association between trade, financial
activity, and per capita GDP and the growth of derivatives markets in the emerging markets
is documented.4
According to a report published in March 2016 by Market Voice, 28 Asian exchanges

recorded a volume of 9.7 billion, representing more than 30% growth in 2015. This
amounts to nearly 40% of the global market share. China, India, Korea, Singapore and
Taiwan were the major contributors to the growth in exchange-traded derivatives
transactions. These figures indicate the increasing popularity of leverage-based products in
emerging Asian markets.
4Mihaljek and Packer (2010) highlighted the specifics of derivatives markets in their study.
9
4. Regional Derivatives Markets

Tables 3 and 4 present the volume of contracts traded5 on financial as well as commodities
exchanges in Asia. It is evident from Table 3 that PMEX is one of the smallest commodities
exchanges in the region, only to be followed by Indonesia. India has the most active
financial and commodities derivatives markets. As compared to Pakistan,6 the financial
derivatives markets in India are mature and nearly two decades old7 and have experienced
tremendous growth after the elimination of Badla8 transactions in 2001.9
While India is leading the way with respect to the number of contracts traded on the four
Indian exchanges, China is leading the way in product innovation and has introduced
derivatives based on non-traditional commodities. It is also catching up with India in terms
of the number of contracts. While innovation in non-traditional commodities appears to be
the hallmark of Chinese derivatives markets, Japan’s innovation in financial derivatives is
evident.
Table 3: Top Regional Derivatives Markets by Number of Contracts Traded
EXCHANGE JAN-DEC 2015 JAN-DEC 2014 % CHANGE
India (IN) 3,921,128,367 2,868,534,687 36.69%
National Stock Exchange of India 3,031,892,784 1,880,363,732 61.24%
BSE 614,894,523 730,173,169 -15.79%
Multi Commodity Exchange of India 216,346,961 133,751,848 61.75%
Metropolitan Stock Exchange of India Ltd 57,994,099 124,245,938 -53.32%
China (CH) 3,558,744,050 2,505,855,692 42.02%
Dalian Commodity Exchange 1,116,323,375 769,637,041 45.00%
Zhengzhou Commodity Exchange 1,070,335,606 676,343,283 58.25%
Shanghai Futures Exchange 1,050,494,146 842,294,223 24.72%
China Financial Futures Exchange 321,590,923 217,581,145 47.80%
Japan (JP) 435,258,320 372,798,844 16.75%
Japan Exchange 361,459,935 309,732,384 16.70%
Tokyo Commodity Exchange 24,399,068 21,856,063 11.64%
Tokyo Financial Exchange 48,986,442 40,900,523 19.77%
Osaka Dojima Commodity Exchange 412,875 309,874 33.24%
Taiwan (TW)
Taiwan Futures Exchange 264,495,660 202,411,093 30.67%
Hong Kong (HK)
5Volume for exchange-traded futures and options is measured by the number of contracts traded on a round-
trip basis to avoid double-counting. Open interest for exchange-traded futures and options is measured by
the number of contracts outstanding at the end of the month.
6Table 5 presents the details of turnovers and values of the derivatives contracts traded on the Pakistan Stock
Exchange.
7Gahlot and Datta (2011).
8‘Badla’, an Urdu/Hindi term meaning ‘to return’, is the unique sub-continental mode of purchasing shares by
leveraging oneself. It is a repurchase agreement, also known as Carry Over Trade (COT), between the buyer
and seller.
9JP Morgan (2007).
10
Hong Kong Exchanges 189,824,363 142,439,039 33.27%

Thailand (TH)
Thailand Futures Exchange 48,538,899 36,021,150 34.75%
Malaysia (MY)
Malaysia Derivatives Exchange 14,060,527 12,313,490 14.19%
United Arab Emirates (AE)1 16,215,204 13,908,999 16.58%
Dubai Gold & Commodities Exchange 14,505,316 11,789,063 23.04%
Dubai Mercantile Exchange 1,709,888 2,119,936 -19.34%
Pakistan (PK) 2
Pakistan Mercantile Exchange 8,477,834 3,776,229 124.51%
Indonesia (ID)
Indonesia Commodity & Derivatives Exchange 575,896 691,238 -16.69%

Note: 1Futures contracts on individual stocks listed on the UAE exchange started trading on
Nasdaq Dubai in September 2016. There is no data available for comparison purposes.
2Financial Derivatives in Pakistan trade on the Pakistan Stock Exchange. The annual
figures could not be reported due to unavailability of data.
11
Table 4: Products Offered at Regional Derivatives Markets

Derivatives IN CH JP TW HK TH MY AE PK ID
Precious Metals
Gold         
Silver        
Palladium      
Platinum          
Base Metals        
Aluminum          
Copper        
  
Ferrous Metals1      
Iron Ore          
Lead 
        
Nickel          
Stannum (Tin)         
Zinc 
         
Other Metals       
Uranium          
Agricultural Commodities         
Cocoa          
Coffee          
Cardamom 
        
Corn 
        
Corn Starch        
Cattle Feed         
Cotton 
 
       
Egg        
Kapas2 
        
Lean Hog         
Live Cattle          
Mentha Oil 
        
Milk         
Palm Oil 
 
       
Rapeseed        
Rapeseed Meal          
Rapeseed Oil          
Red Beans  
       
Red Chillies         
Rice3          
Shrimp        
Silk          
Soya Bean          
Soya Bean Meal         
Soya Bean Oil          
Sugar   
      
Wheat         
Non-Agricultural Commodities       
Blockboard          
Ferrosilicon          
Fiberboard          
Flat Glass          
Silicon Manganese          
Methanol          
       
12
Derivatives IN CH JP TW HK TH MY AE PK ID
Polypropylene   
Polymer (LLDPE)          
Pure Terephthahlic Acid  
Rubber  
       
Synthetic Resin (PVC)       
Energy        
Biodiesel         
Bitumen        
Brent Crude Oil         
Coal 
       
Coke         
Coking Coal          
Crude Oil         
Dubai Crude Oil        
Electricity        
Ethanol          
Fuel Oil  
       
Gas Oil  
       
Gasoline          
Kerosene         
Natural Gas         
Petrochemicals4         
Financial Derivatives         
Bonds          
Currency    
   
   
Dividend Indices     
Equity  
  
 
    
Equity Indices     
    
Interest Rates      
  
REIT Indices     
Treasury Bonds  
      
Volatility Indices 
      
Weather 
            
Source: Data collected from the websites of various derivatives exchanges (2016)
Notes: IN=INDIA; CH=CHINA; JP=JAPAN; TW=TIAWAN; HK=HONG KONG; TH=THAILAND;
MY=MALAYSIA; AE=UNITED ARAB EMIRATES; PK=PAKISTAN; ID=INDONESIA
1 Includes Steel Rebar, Steel Wires, and Hot Rolled Coils; 2 Kapas is unginned cotton; 3
Includes various varieties of rice, such as Early Rice, Japonica Rice, and Late Indica
Rice; 4 Includes Propane, Butane, Ethane, Ethylene.
5. Derivatives Markets in Pakistan

Derivative’s trading in Pakistan is rather nascent. While the trading of equity-based
derivatives on the Pakistan Stock Exchange (PSX)10 started in 2002, commodities
derivatives started trading on the PMEX in May 2007. The trading of OTC derivatives under
10All
three exchanges (Karachi, Lahore and Islamabad) were integrated into Pakistan Stock Exchange (PSX)
on 11 January 2016.
13
the State Bank of Pakistan started in early 200011; however, limited information is available
on such transactions. The PSX and PMEX provide regulated platforms for the online trading
of derivatives on equity, indices, various commodities, and more recently in interest rates
(KIBOR). Figure 5 presents the details of the underlying traded on the organized exchanges.
Figure 5: Derivatives Markets and Products in Pakistan
Derivatives Markets in Pakistan
OTC1,2,3 Organized Exchanges
Pakistan Mercantile Exchange Pakistan Stock Exchange
Interest Equity Equity

Deliverable Cash Settled Index Cash Index
Rates Futures
Settled Deliverable
KIBOR Commodities Futures Futures Futures Options
Futures
Source: PSX (2016); PMEX (2016)
Notes: 1Some unregulated OTC derivatives transactions were conducted by large banks in the
early and mid-2000s, which were overseen by the State Bank of Pakistan.
2According to some industry professionals, organizations engage in forward
transactions under the auspices of the State Bank of Pakistan that are much larger in
scope and magnitude as compared to the exchange-traded transactions. However, the
data is not publicly available.
3The State Bank of Pakistan has introduced a Derivative Transaction Reporting System
(DTRS) that requires all OTC derivatives transactions to be reported on weekly basis
(Dawn, 2015b).
Figure 6 presents the chronology of the inception and development of PMEX. PMEX is a
demutualized and technology-driven on-line commodities exchange that employs Value-at-
Risk (VaR)12 for risk management and has introduced various contracts to suit the needs of
domestic investors. PMEX operates on the concept of a Central Counter Party (CCP),
whereby PMEX’s clearinghouse becomes the counter party to all buyers and sellers. It is
regulated by the Securities and Exchange Commission of Pakistan (SECP) and its
shareholders include National Bank of Pakistan, PSX, LSE Financial Services Limited, ISE
11According to the IOSCO (2010, p.19) report, the OTC derivatives market was largely unregulated. Some
transactions related to government securities were regulated by the State Bank of Pakistan. Currently, there
is no active OTC market in Pakistan. The Pakistan Stock Exchange is planning to open an SME counter to
enable small and medium sized companies to benefit from derivatives transactions.
12Value-at-Risk (VaR) measures the odds of losing money. It has three components: the expected loss, time
period and confidence level.
14
Towers REIT Management Company Limited, Pak Brunei Investment Company Limited,
Pak Kuwait Investment Company (Pvt.) Limited, and Zarai Taraqiati Bank Ltd.13
Figure 6: Chronology of the PMEX

May 2007
October 2003 Operations started August 2007
April 2002
Management with the introduction First physical gold
Company formed
appointed of gold futures delivery
contract
April 2010
February 2012 September 2009 March 2009
Overtook Lahore Stock National Bank of Market making
Wheat futures Exchange to become Pakistan became arrangement was
launched 2nd biggest exchange in
shareholder introduced
the country
March 2013 June 2015 October 2015 September 2016

Currency contracts Hybrid red chilli &
International cotton Contracts on red chills
through COTS longer dated contracts
launched launched
launched launched
Source: PMEX (2016)

The futures contracts offered at PMEX include varying sizes of gold and silver contracts,
rice, palm oil, crude oil, wheat, currency through COTS, sugar, cotton, red chilli, and interest
rate contracts. During FY 2015-16, 3.69 million commodity futures contracts worth PKR
1.3tillion were traded at PMEX. Gold is the most widely traded commodity on the PMEX
followed by currency through COTS, crude oil, silver, cotton, and red chilies respectively.14
Figures 7 and 8 present the details of trading activity and the number of active investors
(traders and brokers) respectively during 2009 and 2015. While the numbers have
increased significantly since 2009, the market is unable to maintain and expand the
number and value of contracts traded.
13The information presented in this section is extracted from the PMEX website (2016).
14Data provided by PMEX.
15
Figure 7: Trading on the PMEX (2009 to 2015)
600,000 225
Value Traded [RHS] Contracts Traded [LHS]
200
Value Traded in Rupees Billions

500,000
175
400,000 150
Lots traded
125
300,000
100
200,000 75
50
100,000
25
- -
Jan 10
Jan 11
Sep-09
Sep-11
May-12
Sep-12
May-13
Sep-13
May-14
Sep-14
May 10
May 11
Sep 10
Jan-12
Jan-13
Jan-14
Jan-15
Source: PMEX (2015)
Figure 8: Active Traders and Active Brokers at the PMEX
14,000 UINs [LHS] Active Traders [LHS] Active Brokers [RHS] 80
12,000 70
Number of Active Brokers

60
10,000
50
Number of UINs
8,000
40
6,000
30
4,000
20
2,000 10
- -
May-07
May-08
May-09
May-10
May-11
May-12
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-14
Jan 13
Jan 14
Jan 15
May 13
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Sep 12
Sep 13
May14
Source: PMEX (2015)

Notes: UIN=Unique Identification Numbers
As compared to the PMEX, the PSX has a long history. The market has transitioned from
various leverage-based products, such as Badla or Carry Over Transactions (COT) and
Continuous Funding system (CFS) to more regulated margin financing and exchange-
traded financial derivatives. The PSX offers futures on selective stocks and more recently
both future and options on indices. As of July 2016, the PSX offered 30-day, 60-day, and 90-
day future contracts on 39 companies (PSX, 2016). However, trading takes place in 30-day
futures contracts only. It also offers index-based futures and options. According to a recent
announcement, the PSX will also be offering equity based options in the near future. Figure
9 presents the historical annual data (2002-2015) of the turnover and the associated
16
monetary values of derivatives traded on the PSX and Table 5 provides insight into the
historical average daily volumes and trading values.15
Figure 9: Annual Turnover and Trading Value of Derivatives Traded on the PSX
9,000,000 100,000
8,000,000 90,000
7,000,000 80,000
PKR Millions
70,000
Millions
6,000,000
60,000
5,000,000
50,000
4,000,000
40,000
3,000,000
30,000
2,000,000 20,000
1,000,000 10,000
0 0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Ready Market Deliverable Futures Market Ready Market Deliverable Futures Market
Table 5: Historical Average Daily Volume and

Value of Derivatives Transaction on the PSX
Deliverable Futures
Ready Market
Market
Avg Value Avg Value
Avg Daily Avg Daily
Year* of Daily of Daily
Turnover Turnover
Turnover Turnover
In PKR in In PKR in
Millions Millions Millions Millions
2002 167 5,963 35 1,721
2003 309 15,686 54 3,907
2004 344 17,409 70 4,914
2005 366 33,583 117 15,461
2006 261 31,611 83 13,588
2007 268 25,263 62 9,078
2008 147 14,228 31 5,230
2009 180 7,451 1 90
2010 133 4,405 5 397
2011 97 3,506 6 612
2012 198 4,675 13 863
2013 239 7,604 22 1,869
2014 219 9,402 24 2,205
2015 257 11,416 36 3,125
Notes: *As of 31 December each year
Data for Cash Settled Futures is not available
15 Data was provided by the PSX data department.
17
5.1. Regulations for Derivatives Markets in Pakistan

All financial markets are subject to a regulatory framework. The regulations serve three
purposes. First, they provide statutory requirements for the players in the market. Second,
they offer monitoring mechanisms to ensure compliance to regulations. Lastly, they ensure
enforcement of rules by acting against non-compliers. While financial markets are Self
Regulatory Organizations (SROs), an additional layer of external regulation by a regulatory
authority like the SECP ensures that the interests of all participants are looked after.
According to the IOSCO standards, there must be a clear division between the regulatory
responsibilities of the exchanges and the regulator. The regulator is expected to assume
both supervisory and advisory roles to ensure desirable flexibility, maximizing regulatory
effectiveness and minimizing regulatory cost. Accordingly, the SECP’s role plays an
important role in:
 Approving rules, by-laws and regulations of derivatives exchanges.

 Approving the proposed derivatives contracts before the commencement of their
trading.
 Providing regulations for derivatives brokers/dealers with respect to capital adequacy,
net worth, certification requirement and initial registration.
The members of the PSX and PMEX are required to meet certain regulatory requirements.
The regulatory reforms for derivative markets (SECP, 2012) require all members of the
PMEX to be registered as brokers and mandatory compliance to ‘Fit and Proper’. Similar
requirements are also applicable on the PSX members. Moreover, minimum net worth and
capital adequacy requirements have also been set up for regulated entities in the
derivatives markets.
The SECP recently formulated the Futures Market Act 2016 (SECP, 2016c), which provides
a clear and extensive regulatory framework covering the following:
i. Futures exchanges on matters, such as licencing, offering, position and trading limits
on futures contracts, accounts and auditors, annual reports cancellation of licence to
name a few.
18
ii. Clearing houses entailing licencing eligibility and requirements, their duties as the
central counterparty, audit and annual reports, and their actions in case of default by
an investor.
iii. Futures advisors, brokers, and representatives with respect to their conduct,
accounts, capital requirements and audit.
iv. Insider trading and market manipulation.
The Act clearly outlines the supervisory, investigative and disciplinary role of the SECP
with respect to the parties and actions mentioned above.
The PSX and the PMEX in their SRO capacities are required to determine maximum
exposure limits, mark to market margins, margin collection from clients and segregation of
clients’ funds, regulation of sales practice, and accounting and disclosure requirements for
derivatives trading.
The concept of market makers was introduced to promote liquidity in commodities

derivatives markets with certain restrictions. The market making arrangements are not
available in the financial derivatives markets as yet. The regulatory framework for the
trading of equity options was approved in April 2012. It allowed options trading through
the electronic platform of PSX and stipulated that option writing would be limited to
eligible brokers and financial institutions as determined by the PSX and SECP (SECP, 2012).
Table 1 in Section 1 presents the characteristics of options and futures contracts. Table 6
presents the mechanisms and regulation of the contracts applicable on demand-side
market participants on the PSX and PMEX.
Table 6: Margin and Guarantee Requirements at the PSX and PMEX

PSX PMEX
Index Options Index Futures Equity Futures Futures
Paid in Cash by the
Buyer
Premium Collection at T+0 Not applicable Not applicable Not applicable
and Distribution to
the Seller at T+1
Applied as per
Exchange’s Risk
Pre-trade Charged @ 5% of Charged @ 5% of order
Not Applicable Management
Margin order value value.
Methodology based
on VaR
Exposure Seller: Payable in Calculated by Deliverable Futures: 50% 75% of the Initial
Margin 100% in Cash applying VaR of the in cash and/or bank Margin
19
and/or Bank underlying index guarantee and 50% in

Guarantee calculated by the margin eligible securities
Buyer: Not Risk Meter at the Cash Settled Futures:
required end of each trading Calculated by 99% VaR.
day. Payable in Payable in 100% in cash
100% in cash and/or Bank Guarantee
and/or bank
guarantee
Applied as per
Payable in 100% in
Special Exchange’s Risk
Not applicable Cash and/or Bank Not applicable
Margin1 Management
Guarantee
Methodology
Deliverable Futures and
Cash Settled Futures:
Concentration
Not applicable Not applicable 100% in Cash and/or Not applicable
Margin2
Bank
Guarantee
Deliverable Futures:
The notional loss Payable in 100% in Cash
Applied as per
and profit arising Cash Settled Futures: The
Mark-to- Exchange’s Risk
out of mark to notional loss and profit
Market Management
market is paid / arising out of mark to
margins Methodology based
received on T+0 market is paid / received
on VaR
basis in cash. on T+0 and T+1 basis
respectively in cash.
Next trading day
Exercise
after expiry of the Not applicable Not applicable Not applicable
Settlement
Options Contract
Price used to determine
profit or loss for the day,
Calculated on the as well as margin
Based on daily mark-
Profits and basis of Exercise requirements.
to-market up to the
Losses Settlement Index Settlement prices are
client level
Level calculated based on
bid/ask of scrips in
ready market
Source: PSX (2016)
Notes: 1Regulations governing the Stock Index Futures Contracts require the open position
holder to pay all the differential amount as “Special Margins” when the price of the
contract is outside the band of a specific percentage 15% or 20%, whichever may be
applicable.
2Concentration Margin is calculated and payable at the end of each trading day by a
TREC Holder as a guarantee in Deliverable Future Contracts and Cash-Settled Futures

Contracts.
6. Determinants of Successful Derivatives Markets

The financial derivatives market in India and the commodities derivatives market in China
have progressed in leaps and bounds in the recent years (refer to Table 3). These markets
have also contributed significantly to the growth of exchange-traded derivatives in the
Asian emerging markets in 2015 (Market Voice, 2016). The literature identifies various
factors for the success of derivatives exchange in a particular country, such as political
stability and subsequent economic development, a robust legal and regulatory framework,
20
sound infrastructure, deep and broad capital markets, the variety of products traded,
informed and educated investors and market participants, and active retail and
institutional investors.16 While some factors highlighted above are macroeconomic, this
section will primarily focus on the characteristics of markets and products that contribute
greatly to the success of derivatives markets.
6.1. Characteristics of the Underlying

Certain core prerequisites of the underlying are required for the derivatives contracts to be
successful, such as ‘price transparency and volatility; large, competitive cash or underlying
markets; lack of suitable cross hedge; freedom from government interference or excessive
regulation; a homogenous product with established grades and standards for quality and
quantity; competitive or strategic considerations; and product support’.17 Most emerging
markets learned from the experience of their developed counterparts in offering
derivatives with a specific underlying. However, China has lately taken the lead in offering
non-traditional products which may satisfy most of the above characteristics, but are not
offered in developed markets.
6.2. Size of the Spot Market

The spot market refers to a market where transactions are settled immediately on spot
prices. The size of a spot market is positively correlated with the growth in futures volume
traded on the derivatives exchange.18 Moreover, research also provides evidence that a
contract written on volatile underlying assets is more successful.19 Since one of the prime
purposes of derivatives is to manage risk, a ‘sufficiently’ volatile underlying would draw
more interest from risk adverse investors.
6.3. Hedging Effectiveness

In most cases, investors use financial and commodities derivatives for hedging or risk
management. Accordingly, derivatives should be able to provide an effective hedge against
the adverse price movements of the underlying. The relevance of ‘hedging effectiveness’ for
16Kim and Mugo–Waweru (2012).

17Mugo-Waweru and Yu-Kyung (2013, p. 74).
18Corkish, Holland and Villa (1997).
19Cornell (1981).
21
the success of a hedging instrument has also been highlighted in the literature,20 which
emphasizes the need for thorough market research to identify institutional market
participants who assume undiversifiable risk and then offer contracts on the appropriate
underlying that may help the investors manage risk efficiently and effectively.
6.4. Market Liquidity

In liquid markets, securities can be bought and sold quickly with minimum loss of value
and a low transaction cost. Liquid markets enable investors to enter and exit the markets at
their discretion. The liquidity of a market can be measured on the following four
dimensions: transaction costs, breadth and depth (volume-based liquidity), efficient price
discovery, and lastly, resilience to shocks.21 In a trade-off between hedging effectiveness
and liquidity, the investors tend to forego the former to some extent for the latter. Liquid
markets mitigate the execution risk and keep bid-ask spreads in check.22 Larger markets
tend to be more liquid; hence, the liquidity in the markets can be considered a consequence
of larger and more successful markets rather than a cause23 in the earlier stages. Once the
markets have attained a certain level of liquidity, they attract more investors.
7. Challenges in the Development of Derivatives Markets in Pakistan

The organized derivatives markets in Pakistan, especially the commodities market, are in
their embryonic stage. Historically, the need for leverage-based products was met by
Badla/CFS transactions that were prevalent in the PSX until 2009.24 Such products may
partially be blamed for hindering the growth of derivatives markets in Pakistan.25
However, a gradual and steady rise has been observed in recent years, possibly because
Badla transactions are no longer undertaken.
Derivatives in India at the National Stock Exchange (NSE) and the Bombay Stock Exchange
(BSE) started trading in 2000 and 2001 respectively.26 The Indian derivatives markets
were able to overcome teething problems in a short span of time and today derivatives
20Tashjian (1995).
21Sarr & Lybek (2002).
22Tesler (1981).
23Corkish, Holland and Villa (1997).
24Dawn (2009).
25JP Morgan (2007).
26Vashishtha and Kumar (2010).
22
trading in India is the highest in the region (refer to Table 3). The Indian markets have
progressed both in terms of value and number of contracts traded and product innovation.
In Pakistan, the trading of equity-based derivatives started in 2002 and commodities-based
derivatives started in 2007. However, the volumes and the value of the contracts have not
evolved greatly over time (refer to Figures 7, 8, and 9, and Table 5). This indicates a lack of
interest of the market participants in such products the reasons of which remain largely
unexplored.
A study conducted in Indian derivatives markets27 highlighted a variety of supply-side

concerns, such as lack of liquidity, ambiguity in valuation and pricing of derivatives,28 tax,
regulatory and accounting concerns, volatility in the underlying, especially in stocks, and
finally, the difficulty in quantifying the impact of derivatives on cash market exposure due
to illiquidity. These concerns and challenges may be relevant in the Pakistani context also.
This section will attempt to highlight various supply and demand side challenges that have
potentially impeded the development and growth of derivatives markets in Pakistan. The
section will derive some inferences from regional markets and will cite the appropriate
literature on the topic.
7.1. Supply-side Challenges

A feasibility report published by the SECP (2006) provided some recommendations and a
road map for the development of derivatives markets in Pakistan, largely from a regulatory
perspective. The committee responsible for the report highlighted the need for adequate
legal, regulatory, and governance infrastructure and oversight, an open licensing regime for
qualifying exchanges, a functional and pragmatic risk management framework,
independent market and member surveillance, central counterparty, clearing and
settlement structure, and effective enforcement by the SROs and APEX regulator. The
report also pointed out the need for bringing the equity derivatives traded on the PSX up to
international standards and also suggested the introduction of new products in organized
markets. Most of these recommendations were implemented through the SECP reforms in
27Srivastava
et al. (2008).
28Theambiguity relates to the benchmark interest rates and the complexity of valuation models such as
Black-Scholes option pricing model.
23
2012. The report, however, did not address other challenges that may hinder the
development and growth of the derivatives markets in Pakistan.
7.1.1. Product Innovation

There is evidence that the success of derivatives markets is highly dependent on the
products introduced and offered in the market.29 Although the SECP in the past has played
a crucial role in developing products appropriate for financial markets in Pakistan, the
responsibility of product development remains with the commercial forefront of the capital
markets, that is the exchanges. The PMEX and PSX have gradually and successfully
introduced various derivatives products that are relevant to the economic sectors in
Pakistan. While the exchanges have risen to the challenge, a lot more is left to be desired.
For example, the exchanges have not been able to offer and promote Shariah-compliant
derivatives. Although most commodities-based derivatives have real underlying assets, the
perceived element of speculation associated with derivatives in general deprives them
from attracting investors who wish to avoid ‘Maisir’30 and ‘Gharar’.31
7.1.2. Regulatory Framework

There seems to be a consensus between investors, regulators, and policy makers that the
alleged opaqueness and complexity of OTC derivatives markets are a potential source of
high volatility and systemic risks. They also believe that excessive use of unregulated OTC
derivatives was a prime cause of the Global Financial Crisis of 2008 (henceforth GFC). This
may seem counter-intuitive as derivatives are considered appropriate for risk
management. This suggests that markets are prone to crashes when such complex
instruments are used excessively and are either unregulated or loosely regulated.
The PSX and the SECP have taken initiatives for the development of derivatives markets
and to encourage investors to use derivatives for managing risk as well as earn reasonable
profit through such transactions. However, historic excessive volatility in the PSX and
subsequent market crashes have forced them to introduce stringent regulations, which on
29Tsetsekos and Varangis (2000).

30An Arabic term for speculation. Shariah prohibits transactions that rely on chance or speculation rather
than effort to produce a return. This can create problems in relation to contracts that are seen as
tantamount to gambling, which includes some conventional derivative transactions such as swaps, futures,
and options.
31An Arabic term for excessive uncertainty.
24
one hand safe-guard investors’ interest but on the other restrict investors to opt for
derivatives in their portfolios. For example, Table 6 clearly highlights the high margin and
collateral requirements for market participants. These requirements restrict the cash
liquidity of the brokers and increase their opportunity costs, subsequently forcing them to
forgo derivatives as an investment option to retain cash liquidity for alternative investment
opportunities that may produce higher returns.
It is therefore important for regulators to be vigilant in introducing regulations that achieve

the purpose of restricting excessive risk-taking but also do not impede the growth and
development of derivatives markets.
7.1.3. Transition from Badla to Derivatives

The NSE abolished Badla transactions in 2001 and started introducing various derivatives
in 2000 and 2001. The transition from one leverage-based product to the other was natural
and relatively smooth in the Indian context. On the contrary, the parallel provision of the
two leverage based products, Badla/CFS and derivatives until 2009, created a competition
between them, with the latter being more regulated and standardized. It is not surprising
that the Pakistani investors continued to use the loosely regulated products which they
were more familiar and comfortable with, hence undermining the importance of
derivatives instruments and markets in Pakistan. It is evident from Figure 7 and 8 that the
value and number of contracts traded, number of active brokers and Unique Identity
Numbers (UINs) at the PMEX have increased substantially after 2009; however, the
number of active traders has increased at a slower rate. This may indicate that the parallel
offering of Badla/CFS and commodities derivatives was weighing down on the later.
7.1.4. Illegal Forex Trading

Illegal forex trading is a major impediment in the development of derivative markets in
Pakistan. There is no formal data available on the magnitude of illegal forex transactions in
Pakistan. However, a report published by Forex Magnates (2012) suggests that cash-based
and informal economy in Pakistan constitutes nearly 40% of the GDP. According to the
above-mentioned report, investors in Pakistan were introduced to margin and leveraged-
based trading in 1990s. Some brokerage firms enticed investors to trade in forex and other
securities in exchange for fixed high returns on the investments. This was problematic, as
25
investors lacked the knowledge to trade in forex and brokers did not reveal the market
risks associated with such investments. To make the matters worse, there was no
regulatory framework to regulate these transactions.
The eventual intervention of the regulator in August 2003 (SECP, 2003) resulted in
penalties and suspension of the brokerage licences of firms involved in such transactions
(SECP, 2003).32 However, the illegal forex trading activity could not be curtailed to the
fullest, as some brokers continued to operate from abroad. Moreover, technological
advancements facilitated such transactions between parties involved. The crackdown on
such companies is ongoing and public awareness campaigns are run by the SBP and the
SECP to educate investors about such fraudulent companies.33
Such schemes have kept potential investors away from organized derivatives exchanges as
they do not seem to comprehend the mechanisms of the derivatives, and their risk and
return profiles.
7.1.5. Brokers and Dealers Education

Derivatives are exceptionally complex and therefore the market participants dealing in
such instruments require appropriate skills. It is essential for all market participants to be
fully educated and trained in their pricing and valuation as well as in their trading. The
establishment of the Institute of Financial Markets of Pakistan (IFMP), formerly Institute of
Capital Markets (ICM), has been critical as it provides a platform for the brokers and
dealers to get adequately educated about the market products, including derivatives, and
then get assessed to acquire a licence to trade in equities and derivatives. Professional
qualifications such as the CFA also equip candidates and charter-holders to deal in
derivatives with care and diligence. However, much more must be done to enable brokers
and dealers to seize investment opportunities associated with derivatives, while upholding
the investment objectives of their clients’ portfolios.
32The SECP released the names of 39 companies that marketed themselves as ‘International Brokerage
Companies’ that were involved in the trading of securities, currency trading, futures currency trading,
money markets, securities’ index trading, commodity futures, options, bonds, etc.
33SECP’s initiative ‘Jama Punji’ is one example of such campaigns.
26
7.2. Demand-side
There are several demand-side challenges that have hampered the growth of Pakistan’s
financial markets in general. Some of them have already been highlighted and discussed in
the SECP (2016a) Capital Market Development Plan. This sections aims to elaborate on
some of the challenges in detail.
7.2.1. Low Savings Rate

Figure 10 clearly indicates that Pakistan has the lowest savings rate in the region, which
has been stagnant since 1980 and even earlier. Other countries in the region have
maintained comparatively high savings-to-GDP ratios, which have risen in the recent years.
The average and median savings rates in Pakistan are nearly 50% and 75% less than those
of India and China respectively. The lowest data dispersion around mean and near zero
skewness is also indicative of stationarity in savings in more than three decades. This
constraint has impacted the growth of the banking industry and financial markets.
Although this issue has been highlighted several times in relation to the underdevelopment
of capital markets in Pakistan, the reasons have not been examined thoroughly. Lack of
insight has therefore restricted the government and various stakeholders from introducing
measures that may promote savings in the masses.
Figure 10: Regional Savings to GDP Ratio

60
50
40
30
20
10
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Bangladesh Pakistan Sri Lanka India China
Mean Median SD Skewness

Bangladesh 14.7589 16.5314 5.6604 -0.4182
China 41.4451 41.1289 6.0969 0.3047
India 25.1007 23.5080 5.0492 0.3176
Pakistan 11.9607 11.3655 3.8457 0.0692
Sri Lanka 16.4343 15.9912 3.9665 0.9198
Source: World Bank (2016a)
27
7.2.2. Limited Investor Base

Pakistan capital markets have witnessed increased portfolio investments inflow in equities
over time (refer to Figure 11 for a regional comparison). A closer look at the equity inflows
suggests that the inflows have followed similar patterns in India and Pakistan, although the
net equity inflows are much smaller in Pakistan. The descriptive statistics also provide an
insight into the net equity inflows. While China and India seem to be receiving
exceptionally high equity inflow, the interest of foreign investors in Pakistan is also evident
from moderately high standard deviation and positively skewed inflows.
Figure 11: Regional Net Portfolio Equity Inflows (BoP, current USD)
1500
55000
45000
USD Millions
USD Millions
35000 500
25000
15000
-500
5000
-50002001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
-15000 -1500
China (LHS) India (LHS) Bangladesh (RSH) Pakistan (RHS) Sri Lanka (RHS)
Mean Median SD Skew
Bangladesh* 55.10 0.82 117.112 1.93185
China 20879.87 19523.56 15849.3 0.47557
India 11923.51 10830.16 13400.5 -0.2365
Pakistan 295.79 95.00 475.237 1.09508
Sri Lanka -184.25 -157.30 336.639 -1.0945
Notes: Equity Inflows in China and India are plotted on the left axis
*Data for some years is not available
While the portfolio investment has demonstrated an increasing trend, the domestic
investor base in equity markets remains much smaller and has hovered around 250,000
investors (based on UIN data) since the inception of the stock exchange in Pakistan. The
number of registered investors on the PMEX is even smaller and stands at 17,000 investors
as of October 2016.34 On the contrary, markets such as Bangladesh and Turkey have a
much larger investor base of over one million and six million respectively.35 This challenge
is a major impediment to the growth of the financial markets in Pakistan.
34Data provided by PMEX.

35PSX (2014) – Interview of the PSX MD, Mr. Nadeem Naqvi.
28
7.2.3. Liquidity Constraints

This refers to market liquidity as well as availability of cash with the market participants to
cover margin and other requirements. As discussed in Section 5, both financial and
commodity derivatives are thinly traded at the PSX and PMEX. Accordingly, to promote
liquidity in the derivatives market, the PMEX allowed market-making arrangements.36
However, this has not yet induced significant liquidity in the derivatives contracts. While
two dimensions of liquidity37 may have been achieved (low transaction cost and speedy
price discovery), both volume based liquidity, that is the depth and breadth of the market,
and resilience to negative shocks still need to be established.
Availability of monetary resources is critical for market participants to meet the need for
various kinds of margins and guarantees. Excessive limitations on cross-margining may
limit the capacity of investors as well as market makers to take positions in derivatives
contracts.
7.2.4. Lack of Investor Education and Confidence

The need for investor education cannot be emphasized enough as it is a major cause of
impediment in the development of financial markets in Pakistan in general. Due to the lack
of knowledge about the attributes of the financial products, market mechanisms, and
fundamental analysis, investors in Pakistan frequently engage in intentional herding,38
which appears to be more prevalent surrounding liquidity crises and specific
macroeconomic announcements such as changes in policy rates and inflation related
announcements.39 This behaviour leads to inefficient pricing of assets, makes the intrinsic
value of underlying assets irrelevant, induces undue volatility in the market, and may cause
market crashes.
The lack of product knowledge and its workings, and the inability to understand the pricing
and valuation of derivatives coupled with the inherent complexity of derivatives leads to
the underdevelopment of derivative markets.
36Such arrangements are common in developed markets such as Hong Kong (HKEX, 2016), Australia (ASX,
2016), and several other markets.
37As described by Sarr & Lybek (2002).
38Intentional herding occurs when investors intentionally follow others due to informational cascade without
performing due diligence and analysis.

39Jhandir and Elahi (2014); Javaira and Hassan (2015); Jhandir and Hanif (2014).
29
Another challenge that Pakistan Capital Markets face is the lack of investor confidence. The
investors consider the markets to be highly manipulated and therefore are not willing to
invest in them. Despite the comprehensive surveillance and enforcements powers of the
SECP, the weakness in the legal system limits its capability of punishing the culprits in a
timely manner,40 thereby eroding investors’ confidence further.
7.2.5. Lack of Viable Investment Alternatives

This challenge can be viewed in the backdrop of a lack of innovation in product
development, lack of investor education, and historically high discount rates. The
exchanges have lagged behind in expanding the products portfolio offered at the PMEX and
PSX. The PMEX has offered several contracts with different underlying assets since it
became operational in 2007, the latest being the contracts on currencies; however, the pace
of product development is slow. Lack of investor education has complemented the problem
as the investors may not be aware of the suitability of products to their investment needs.
High rates offered on government securities have also prevented investors from looking at
alternative investment products.
7.2.6. Limited Outreach of Financial Intermediaries

Approximately 371 members hold the Trading Right Entitlement Certificate (TREC) on the
PSX out of which approximately 335 members are active. All PSX members are eligible to
engage in derivatives transaction on the PSX. On the other hand, 156 registered brokers
(individual members and companies) deal in commodities derivatives on the PMEX.41 Most
of the registered brokers are in large urban areas with a large majority based in Karachi.
This restricts the investors’ participation in smaller cities. The exchanges and the SECP is
taking some measures to improve market accessibility for urban as well as rural investors.
7.2.7. Accounting Related Issues

The accounting standard IAS39 requires all derivatives assets and/or liabilities to be
recorded at fair value, and the recording for changes in their values depends on their
intended use. However, in Pakistan, the State Bank of Pakistan (SBP) has developed its own
criteria for the recognition and measurement of financial instruments, which obscures the
40IOSCO (2015) Country Report argues that the civil courts are unable to process the cases related to market
related offences in a speedy manner and there is no provision for prison sentences against insider trading.
41SECP (2016b).
30
gains and losses arising from forward hedging under the transactions associated in dealing
with the foreign currencies. This can be misleading for both retail and institutional
investors, as they may not be able to fully gauge the risks assumed by entities through
trading in derivatives.
8. Future Outlook
The GFC wreaked havoc in world markets. Coincidentally, the Pakistan markets took a
plunge approximately at the same time, giving an impression that the GFC played a major
role in the market crash. It is argued that the 2008 crisis in Pakistan Capital Markets was a
product of domestic problems, such as political instability, poor macroeconomic indicators,
and most importantly, ad hoc policy decisions.42 Moreover, limited exposure to consumer
and private credit (Figure 12), absence of risk heavy complex instruments, and shallowness
of the markets provide the Pakistan markets a buffer from the global crisis and enabled
them to recover from it much sooner than their regional counterparts such as Japan, China,
India, and Malaysia. In fact, Pakistan was the only market in the region that surpassed its
pre-crisis index levels by the end of 2012.43 Furthermore, the market has produced
exceptional returns for the investors and is a part of the ‘Next-11’44 group. This suggests
that the Pakistani financial markets have exceptional growth potential and derivatives
markets can benefit from the factors discussed in this section.
Figure 12: Regional and Global Comparison of Domestic Credit to Private Sector (% of GDP)
42Business Recorder (2015).

43Author’s calculations.
44James O’Neil, an economist at Goldman Sachs, coined the term ‘Next 11’ or ‘N-11’. This is a group of eleven
countries that are in transition to become the world's largest economies in the 21st century.
31
220
170
120
70
20
-30
Bangladesh India Pakistan

East Asia & Pacific United States World

Notes: Pakistan has the lowest ration in the Subcontinent, which has either stayed stagnant
or declined over time.
8.1. MSCI Reclassification
The promotion of Pakistan from the MSCI Frontier Markets Index to the MSCI Emerging
Markets Index in June 2016 has contributed significantly in rising index levels as well as
trading volumes. This will provide PSX the required visibility and credibility in the world
and may lead to higher portfolio investments, which will potentially spill over into
derivatives markets also.
8.2. Economic Growth

Research indicates a positive association between trade, financial activity, and per capita
GDP and the growth of derivatives markets.45 Some macroeconomic indicators have
exhibited positive trends (Table 6). Although the connection between the capital markets
in Pakistan and economic indicators is currently weak, the market does reflect the market
sentiments to some extent. With demutualization of the PSX, a robust regulatory
framework, and appropriate governance mechanisms, the market is expected to reflect the
true potential of the economy, which will in turn contribute towards the development of
the derivatives markets.
Table 6: Macroeconomic Indicators of Pakistan
45Mihaljek and Packer (2010).
32
2010 2011 2012 2013 2014 2015

GDP per Capita (current US$) 1,023 1,213 1,255 1,275 1,315 1,429
GDP Growth Rate (annual %age) 1.60 2.80 3.50 4.40 4.70 5.50
Total reserves current US$ in Billions (includes gold) 17.26 17.70 13.69 7.65 14.31 20.03
Inflation, consumer prices (annual %) 13.88 11.92 9.69 7.69 7.19 2.54
Exports of goods and services (% of GDP) 13.52 13.97 12.40 13.28 12.28 10.95
Imports of goods and services (% of GDP) 19.35 18.97 20.41 20.06 18.72 17.11
8.3. Governance Indicators

Political stability and other key governance indicators are a prime consideration for foreign
and domestic investments. Figure 13 presents the historical trend of selected governance
criteria as determined by the World Bank. It is evident that Pakistan has not made a lot of
progress since 2008. An improvement in these indicators will contribute to the
development of PSX and PMEX.
Figure 13: Governance Indicators for Pakistan (Estimates and Ranks)

Estimates
2008 2009 2010 2011 2012 2013 2014
0.00
-1.00
-2.00
-3.00
Rank
50
0
2008 2009 2010 2011 2012 2013 2014
Voice and Accountability Political Stability No Violence Government Effectiveness
Source: World Bank (2016b)
Notes:
i. Voice and Accountability reflects perceptions of the extent to which a country's citizens are able to
participate in selecting their government, as well as freedom of expression, freedom of association,
and a freedom of press.
ii. Political Stability and Absence of Violence/Terrorism measures the perceptions of the likelihood of
political instability and/or politically-motivated violence, including terrorism.
iii. Government Effectiveness reflects perceptions of the quality of public services, the quality of the civil
service and the degree of its independence from political pressures, the quality of policy formulation
and implementation, and the credibility of the government's commitment to such policies.
iv. Regulatory Quality reflects perceptions of the ability of the government to formulate and implement
sound policies and regulations that permit and promote private sector development.
v. Rule of Law reflects perceptions of the extent to which agents have confidence in and abide by the
rules of society, and in particular the quality of contract enforcement, property rights, the police, and
the courts, as well as the likelihood of crime and violence.
vi. Control on Corruption reflects perceptions of the extent to which public power is exercised for private
gain, including both petty and grand forms of corruption, as well as "capture" of the state by elites
and private interests.
33
8.4. Credit Rating

In October 2016, both Moody’s and S&P upgraded Pakistan’s sovereign credit rating to
B3/Stable and B/Stable respectively. The new credit rating is based on the projected
growth in GDP and GDP per capita, improvement in several economic sectors, low oil
prices, and the investment in the CPEC.46 This enabled Pakistan to secure one billion US$ by
selling Eurobonds at a coupon rate of 5.5%47, which is significantly lower than the coupon
rate of 8.25% offered on the 500 million US$ Eurobonds issued in September 2015.48
8.5. Regulatory Framework and Corporate Governance
The SECP has made a lot of progress in introducing a stringent regulatory framework for
the exchanges as well as the clearing and depository companies, investment companies and
investment professionals. The regulator is striving to comply with the international best
practices as presented by the International Organization of Securities Commissions
(IOSCO). Moreover, the functions of the National Clearing Company of Pakistan Limited
(NCCPL) have been enhanced. The NCCPL now assumes the role of central counter party
and is responsible for clearing, settlement, and risk management functions.
A country report published by IOSCO in July 2015 appreciated the improvements in the
structure and implementation of regulations by the SECP. The report highlighted the
following strengths: broad and comprehensive powers of investigation surveillance and
enforcement, extensive regulation for issuers, sufficient safeguarding of the interests of
minority shareholders, and high accounting and audit standards. Despite these
achievements, a lot more has to be done to bring the regulations and governance structures
at par with the best international practices. Improvement in regulatory infrastructure and
its implementation will attract both local and foreign investors.
According to the World Corporate Governance Index 2015, Pakistan classifies under Group
2 with a Corporate Governance (CG) Score between 40 and 60.49 The highest score on the
index can be 100, which is most prevalent in developed countries. The Pakistan Institute of
Corporate Governance (PICG) along with the SECP, SBP, PSX, and the PMEX is involved in
training and education, creating awareness, undertaking research, publishing guidelines
46Reuters(2016).
47Dawn (2016).
48Dawn (2015a).
49SAHA (2016). SAHA is a local rating agency licensed by the Capital Markets Board in Turkey.
34
and other resource material, and also provides a platform for issues concerning CG in
Pakistan.50
The appropriate regulatory framework coupled with best practices in CG will promote
integrity and credibility of financial institutions, stock exchanges, incorporated companies
and the country in general, and will enhance confidence and trust in domestic and foreign
investors by warranting transparency, fairness, and accountability in relation to all internal
and external stakeholders.
8.6. Strategic Stakeholders

The PSX is in the process of offering 40% of its stake to a strategic investor. Several
exchanges such as Borsa Istanbul of Turkey, the London Stock Exchange, and the Shanghai
Stock Exchange51 have indicated interest in buying this stake.52 This will lead to an
improved regulatory environment, technological advancement, product innovation, better
reputation, and enhanced investors’ confidence.
8.7. Discount and Deposit Rates

Historically, the rate of return offered on government securities was exceptionally high
(Figure 14). The highest discount rate of 19.50% was offered in Oct 1996 and the lowest of
5.75% in May 2016. Most retail as well as institutional investors opted for high-return risk-
free securities instead of investing in volatile markets. High discount rates also dampened
the growth of financial markets as publicly listed companies could not offer such high
returns on equity or debt. Moreover, the crowding-out effect diverted all the investment
from the private sector to the public sector. Lastly, high bank deposit rates also provided an
alternate avenue for savings.53 With the exceptional performance of financial markets in
Pakistan in recent years and low discount and deposit rates (Figure 15), investors may look
for alternative avenues for investment that may provide them with high returns with
acceptable level of risk.
50PICG (2016).
51A consortium of Chinese stock exchange includes the Shanghai stock exchange and two other Chinese
exchanges.
52Business Recorder (2016).
53The inflation rate was in double digits from 2008-2011, so the real interest rates were in fact negative.
35
Figure 14: State Bank of Pakistan Reverse Repo Rates

20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Source: SBP (2016)
Figure 15: Comparison of KSE100 index, Weekly Log Returns, and Deposit Rates
45,000 20
40,000 15
35,000 10
30,000 5
25,000 0
20,000 -5
15,000 -10
10,000 -15
5,000 -20
0 -25
Jan/06 Jan/07 Jan/08 Jan/09 Jan/10 Jan/11 Jan/12 Jan/13 Jan/14 Jan/15 Jan/16
DEPOSIT RATE (RHS) CLOSE (LHS) LOG RETURNS (RHS)

Notes: Weekly Log Returns – Author’s Calculations
8.8. Need for Leverage-based Products
Badla/CFS and lack of margin financing was considered to be the most relevant reason for
the underdevelopment of a proper equity derivatives market in Pakistan (JP Morgan,
2007). The elimination of Badla/CFS in 200954 forced investors to look for alternate
investment avenues that would enable them to reap greater returns through leverage.55
This has provided an impetus to the gradual development of derivative markets in Pakistan
(refer to Figures 7 and 8). While the popularity of derivatives products and markets is
gradually increasing, the trading of such instruments can be boosted by taking some
appropriate initiatives.
54Dawn (2016a)
55The NCCPL provides a Margin Trading System (MTS) on selected stocks and Margin Financing (MF) on all
the stocks available in the market. However, the volumes in MTS and MF have reduced significantly.
36
9. Recommendations
The paper so far has highlighted the challenges faced by regulators, organized exchanges,
dealers and brokers, and investors. While the growth and development of the financial
markets mirror the economic development, governance structure, and regulatory
framework of the country, additional measures can encourage investors’ participation and
more robust capital markets. Some recommendations to promote knowledge of and
interest in derivatives markets are discussed in this section.
9.1. Understanding the Concerns of Brokers

First and foremost, it is essential to evaluate the challenges faced by the intermediaries that
play a crucial role in executing derivatives transactions. As identified by Srivastava et al.,
(2008), the major concerns of dealers and brokers in India were related to tax and
accounting treatments of derivatives. Qualitative and quantitative research may result in
useful insight about the challenges faced by the supply-side market participants, which
may in turn enable the exchanges and the SECP to devise appropriate measures to address
these concerns and thus encourage them to promote trading in derivatives markets.
9.2. Education and Awareness among Various Stakeholders

During the research phase of introducing derivatives in the Indian financial markets, the
committee heading the task found that that there is a lack of knowledge regarding the
objectives and workings of derivative instruments as a hedging and risk management
mechanism amongst the trading community as well as the end users. Subsequently, the
committee suggested mandatory training for all supply-side market participants and the
NSE obliged.56
While the SECP, PSX, and PMEX have taken appropriate measures to educate investors and
thereby encourage their participation in the financial markets, IFMP has been mandated to
provide courses and assessments for licencing the brokers, dealers, and other market
participants. An initiative by the SECP, ‘Jama Punji’, is educating masses about the various
financial products available in the markets and their suitability to retail investors. The
following steps can be taken to increase financial literacy amongst investors:
56Rehman and Hassan (2011).
37
i. The first step is to conduct research to assess the existing financial literacy amongst
potential investors and then to produce relevant educational materials.
ii. Publish (in print and online) targeted investor guides in plain and simple language
and if possible in both English and Urdu.
iii. Identify more product specific and generic risks in investor guides in order to enable
investors to evaluate the suitability of the products to their needs.
iv. Encourage investors to seek professional advice before making investment decisions.
v. Collaboration with universities, professional bodies, and academia will not only
enhance investors’ education but will also produce trained professionals. These
collaborations can be promoted as follows:
a. Encouraging market based research by timely provision of public data
b. Organizing field trips to PMEX and PSX for university students
c. Guest speaker sessions in relevant undergraduate courses
d. Workshops for professional through executive education arms of universities
e. Short certificate courses for investors
f. Competitions for students focusing on mock trading of derivatives
9.3. Increasing Investor Base and Confidence Building

Having a diverse and large investor base is crucial for the growth and development of
financial markets. Several measures need to be taken to build investors’ confidence,
especially retail investors, and encourage them to invest in the Pakistani capital markets.
The success of exchange traded derivatives in India is attributed to the greater
participation of retail investors in the market.57 To achieve these objectives, it is crucial to
take certain measures. These measures are discussed below.
9.5.1. Research
While institutional participation is important for the development of financial markets, the
interest of retail investors is equally important. However, little is known about the needs,
preferences, and reservations of retail investors in Pakistan. A detailed insight into the
savings and investment preferences and the associated reasons is required in order for the
57ISMR (2011).
38
PSX and PMEX to introduce relevant financial products and attract greater participation
from retail investors.
9.5.2. Accessibility
As discussed in Section 7.2.6, the head and representative offices of broker houses are
concentrated in urban areas. To increase the investor base from smaller cities and towns,
accessibility to these brokers is paramount. Accordingly, the PSX has introduced some
trading facilities in Lahore and Islamabad and is collaborating with the SECP to establish
‘Capital Market Hubs’. One such facility is already operational in Abbottabad. Moreover, the
PSX has also provided online facilities to all its TREC holders, which in turn has enabled
them to provide market access to all urban and rural investors.
Besides the above-mentioned initiative, several other measures can be taken to increase
market accessibility, such as:
i. Introducing appropriate regulations to increase the network embeddedness of

brokerage houses.
ii. Encouraging dealers and brokers to operate satellite offices in smaller cities and
towns.
iii. Promoting remote connectivity between the dealers and investors through the
internet58 and mobile phones.59
iv. Partnering with banks that already have an expansive network across Pakistan and
offering investment opportunities through their branches. This is already being
exercised by the insurance industry and many banks now offer bancassurance.
9.5.3. Transparency and Accountability

The Pakistan capital markets have been quite volatile in the past and have witnessed
frequent market crashes. Investors generally hold negative sentiments towards the market
due to perceived market manipulation and insider trading. The exchanges and the
regulators have taken several measures to project a positive image of the market; however,
these measures have not been fruitful in changing the sentiments of the population. Easy
access to relevant information, such as clear and detailed information on margin, collateral,
58According to the World Bank’s (2014a) estimates, 14 out of 100 people use the internet.
59According to the World Bank’s (2014b) estimates, 73 out of 100 people are subscribed to a mobile network.
39
and guarantee requirements, is of prime importance to investors. Such information can be

easily made available on the websites of exchanges and the regulator, which currently are
not only deficient in this regard but are also very difficult to navigate. Provision of relevant
public disclosures by the market participants, timely dissemination of market related
information by the SROs and the regulator, and punitive measures for stakeholders
involved in false practices may help in stimulating investors’ confidence.
9.5.4. Marketing
Appropriate marketing campaigns can be initiated to promote derivatives on various
platforms such as print, television, and social media. For instance, gold contracts can be
marketed as a leverage product that can provide investors with the potential to benefit
from the upside. While it may be difficult for retail investors to invest in the commodity
itself due to a requirement for high investment, gold derivatives may enable them to make
profits with minimum investments. The SECP has already taken measures related to
monitoring and addressing compliance issues in advertisements, disclosure, and conduct.
These regulations can be extended to include all marketing platforms.
9.4. Product Innovation

As the markets mature and domestic investors become willing to consider derivatives as
potential risk management or profit making avenues, it would be appropriate to introduce
relevant products, both traditional and non-traditional, to broaden the domestic
derivatives markets. In recent years, many exchanges have started introducing non-
traditional contracts which are aligned with the composition of the economy. For example,
Derivatives’ Exchanges in China witnessed a sizeable upsurge in volume in 2015, which
was attributed to the introduction of futures contracts based on non-conventional
industrial commodities such as Pure Terephthahlic Acid (PTA) and methanol, which are
used in the production of polyester fabric and other types of plastics, and other industrial
chemicals (Futures Industry Association, 2016). This indicates that while derivatives based
on traditional commodities may still be popular in global derivatives markets, newer and
developing markets like Pakistan may benefit from introducing contracts on commodities
that are relevant to industrial production.
40
Furthermore, the popularity and need for Shariah-compliant products is on the rise (Figure
16). The exchanges can look into developing and promoting appropriate products that
fulfill this gap in the derivatives market. It is argued that the current debate on derivatives
and their permissibility in Islam fails to highlight that Islamic contracts already posses
some implicit derivative-like attributes, such as the transfer of assets from lenders to
borrowers, and that the risk associated with the future value of the asset is shared by two
(or more) parties.60 A classification of derivative’s like the arrangement in Islamic Finance
are presented in Table 8.
Figure 16: Growth in Islamic Assets and Country-wise Distribution
Source: MIFC (2016)
Table 8: Classification of Derivatives in Islamic Finance

Type of
Implicit Derivatives Legacy Derivatives61 Explicit Derivatives
Derivatives
Ijara Thumma al-Bay, Salam, Bay Mu’ajal, Bay
Various Commodity
Forward Murabaha, Diminishing Bithaman Ajil,
Hedges
Equity-Musharaka Istisna
Wa’ad, Arbun, Al-Shart, Foreign Exchange Option
Options -
(Kyiyar al-Tarwih) Contracts
Wa’ad-based Swap,
Profit Rate Swap, Cross-
Swap - Tawarruq, Al-Muqasah
Currency
Swap
Source: Jobst and Solé (2012)
Malaysia started offering Shariah-compliant derivatives in 2007 and has since been at the
forefront of innovation in such instruments. The PMEX can learn from the experience of its
Malaysian counterpart in developing and promoting such products.
60Jobst
and Solé (2012).
61Legacy hedges are long-term hedges. Mining companies prefer to have such hedges in place in order to
protect them from adverse price movements.
41
With respect to the financial derivatives, the PSX has already made some progress in
introducing new derivatives such as index futures and more recently, equity options. The
relevance of these instruments to the hedgers and investors’ interest in them is yet to be
gauged.
The introduction of both financial and commodities derivatives requires significant

research and regional comparisons in order to offer products that are relevant to the
investors for risk management. Besides assessing the effectiveness of hedging, it is also
important to base derivatives contracts on financial and real assets that have an active spot
market with significant implied volatility.
9.5. Liquidity
The lack of liquidity in the derivatives markets prompted the PMEX to introduce the
market maker mechanism in 2012. The PMEX and the regulator need to take appropriate
measures to enhance liquidity on the PMEX, which will in turn encourage investors to
invest in derivatives suitable to their needs. This can be achieved by allowing banks to
participate in the derivatives markets as traders as well as market makers. In the former
role, banks can trade for their proprietary treasury accounts and offer commodities to their
clients. In the latter role, banks can facilitate provision of bids/offers throughout the
trading time of 21 hours and at the same time enable investors to enter and exit the market
at their discretion.
While the PMEX has already introduced market making arrangements, the PSX still has to
come up with a similar mechanism. The financial derivatives markets in India benefitted by
opting to allow market makers to provide liquidity in NSE in 2002/2003 and in BSE in
2011. Both exchanges faced challenges in maintaining order in derivatives trading after the
introduction of market making arrangements; however, these markets have learnt
important lessons and the PSX can benefit from the experiences of these markets.
The supply-side cash liquidity, that is the availability of funds with the dealers and brokers,
can also be of major concern. While capital adequacy and other regulatory requirements
are in place to ensure that the market participants are well capitalized, appropriate
42
regulations related to margin requirements and cross margining62 can ease the cash
liquidity concerns in the derivatives market. The latter was found as one of the major
concerns of market participants in NSE India.63
In Pakistan, concerns regarding cross margining relate to the existing foreign exchange
regulations in Pakistan, whereby the market makers in the PMEX are not allowed to remit
funds to cover their open positions in foreign derivatives markets.64 Allowing cross
margining between local and foreign open positions within specific limits, and close
monitoring of such transactions will encourage market makers to induce much needed
liquidity in the PMEX.65 Similar arrangements may be required for market makers in the
PSX to provide them with incentives to deal with illiquid derivatives.
9.6. Pooled Investment Portfolios

The use of derivatives in the US mutual fund industry is very common and substantial. New
laws drafted (but not enforced yet) by the Securities and Exchange Commission of the US
are expected to curtail mutual and exchange traded funds’ total derivative exposure to 150
per cent of the fund’s total assets (Financial Times, 2016).
While the US mutual fund industry has benefitted from relatively loose regulations with
respect to inclusion of derivatives in the portfolios, the mutual funds in Pakistan may have
not been able to benefit at all from such inclusions due to various restrictions implemented
by the regulator. In Pakistan, mutual funds have negligible exposure to derivatives in their
portfolios. For example, under the balance scheme, funds are allowed to sell a single stock
delivery based contract in the futures market provided the fund is already holding the
underlying security. These regulations along with the high margin and collateral
62 Also know as the spread margin. This allows market participants holding off-setting positions to transfer
excess margin from one account to another account whose margin is under the required maintenance
margin.
63 Gahlot and Datta (2011). The National Stock Exchange in India (NSE) allows cross-margining when the
position in futures and options for stock and index futures has the same expiry month. The NSE however,
restrains cross-margining for options contracts.
64 Limitations on foreign remittances are imposed to maintain a country’s foreign exchange reserves.
65
The Regulatory Framework for Market Makers (Section 12) formulated by the PMEX specifies: “The Market
Makers may at their risk avail such facilities as may be provided by the Exchange particularly but not
limited to especially designed trading engine (a risk management tool developed by the Exchange for
Market Makers) to off-set their trades in foreign commodity exchanges against any position which they may
take during market making process at the Exchange” (PMEX, 2016)
43
requirements are too restrictive for the funds to motivate them to invest in derivatives
contracts.
Depending on the investment policy and investors’ preferences, the ceiling for derivatives
in pooled investment funds such as mutual funds and voluntary pension funds can be
adjusted. Moreover, derivatives can be a part of portfolios that use leverage to maximize
returns, but with some regulatory constraints. Funds specifically for derivatives can also be
formulated with stringent regulations and oversight to ensure that the interests of
investors are safeguarded.
9.7. Regulatory Framework and Best Practices

The success of any financial instrument depends on the appropriateness of the products for
the investors and the regulatory framework surrounding it. The triumph of financial
derivatives in India is partially attributed to the changes in regulations associated with
such contracts. The financial derivatives were introduced in phases on the NSE.66 In the
earlier years, all the derivative contracts offered on the NSE were cash settled and did not
involve physical delivery of the underlying as the cost of delivery may be high. 67 The low
costs associated with settlement in a way provided an impetus for growth to the
derivatives markets
At the NSE, equity futures are most popular in terms of the volume and number of
contracts traded, followed by index futures with turnover of 52% and 31%of the total
traded value on the NSE respectively.68 In comparison, the turnover and the monetary
value of exchange-traded derivatives has remained marginal and relatively unchanged on
the PSX (refer to Table 4). In-depth research is required to understand whether excessive
regulations, either imposed by the PSX and PMEX or the SECP, are impeding the progress of
the derivatives instruments and markets in Pakistan or whether this impediment can be
attributed to some other factors. As an example, Table 9 below provides an overview of the
margin and other requirements at the NSE trading in derivatives.
66Index futures were introduced in June 2000, followed by index options in June 2001, and options and
futures on individual securities in July and November 2001, respectively.
67Sarkar (2006).
68Vashishtha and Kumar (2010).
44
Table 9: Margin Requirements for Financial Derivatives at the NSE

Description Comments
System Used for Standard Portfolio Analysis of Risk
Monitoring (SPAN)
The SPAN system uses sophisticated
algorithms to compute margins of each
position to its calculated worst
SPAN margin covers the risk for 99% of
SPAN Margin possible one-day move. Any excess
the days.
margin on existing positions can be
shifted to new positions or existing
positions that are short of margin.
Methodology for computation of VaR
Based on 99% VaR over a one-day time percentage is adjusted based on the
horizon. SEBI’s recommendations from time to
In the case of index or stocks futures time.
contracts where it may not be possible to Separate arrangements are in place for
Initial margin collect mark-to-market settlement value client positions and proprietary
before the commencement of trading on positions.
the next day, the initial margin is Calculation for Initial Margin
computed over a two-day time horizon requirement = Total SPAN Margin
using an appropriate statistical formula. Requirement + Buy Premium +
Assignment Margin
Can be in the form of:
 Cash
Clearing members may provide
 Fixed Deposit Receipts (FDRs) issued by
additional margin/collateral deposit to
approved banks and deposited with
the clearing company and/or may
approved Custodians or the Clearing
Additional Margin / wish to retain deposits and/or such
Company
Collateral Deposit amounts which are receivable from
 Bank Guarantee in favour of NSCCL
NSCCL, over and above their minimum
from approved banks in the specified
deposit requirements, towards initial
format.
margin and/ or other obligations.
 Approved securities deposited with
approved Custodians.
For Options
Premium amount is payable by the buyer
Premium Margin of the option and is in effect till the
completion of pay-in towards the
premium settlement.
For Options
Deducted from the effective deposits
Is applicable until the interim and final
Assignment Margin of the Clearing Member available
exercise settlement obligations for option
towards margins.
contracts on index and individual stocks.
For Index Options and Index Futures
Contracts:
 3% of the notional value of a futures
contract. In case of options it is charged The standard deviation of daily
only on short positions and is 3% of the logarithmic returns of prices in the
notional value of open positions. underlying stock in the cash market in
Exposure Margins
For Stock Options and Futures Contracts: the last six months is computed on a
 The higher of 5% or 1.5 standard rolling and monthly basis at the end of
deviation of the notional value of gross each month.
open position in futures on individual
stocks and gross short open positions in
options on individual securities.
45
Computed by reducing the initial margin

payable at any point in time from the
Liquid Net Worth effective deposits.
The Minimum Liquid Net worth at any
point in time should not be less than
Rs.50 lakhs.
Source: NSE India (2016)
The Malaysian derivatives markets also use the SPAN system and follow similar
mechanisms of calculating margins as adopted by the NSE.69
Besides the appropriate regulations, the use of tools and procedures that are in line with
the international best practices will enhance investors confidence in the Pakistani
derivative markets. For example, the SPAN system is widely used by futures and options
exchanges around the world and is appreciated for its sophistication. It is not clear if the
PSX uses such system to calculate the risk exposure of the portfolios. Use of such system
will take the guesswork out of the margin calculations and will enable investors to used
excess margins towards other open or new positions, hence reducing the opportunity cost
of capital.
9.8. Accounting for Derivatives

As per the IOSCO (2015) country report, the accounting and auditing profession is well-
established in Pakistan. However, these strengths have not been able to overcome the
weakness associated with disclosure regulations and practices. While the SBP has adopted
its own standards for recognition and measurement of derivatives instruments, adoption
and implementation of international accounting standards such as IFRS970 would introduce
proper hedge accounting practices and provide a better understanding of the risk exposure
to derivatives. For publicly listed institutional investors, a severe decline in the values of
derivatives contracts due to systematic or unsystematic risks may significantly affect the
earnings and quality of the balance sheet of a company that engages in foreign trade and
uses derivatives for hedging various risks. The resultant financial statements can be
misleading for investors as the gains and losses reported are unrealized. Hence,
69For more information on margin requirements in Malaysian derivative markets, refer to the Oriental Pacific
Futures (2016) website.
70According to IAS Plus (2016) “IFRS 9 Financial Instruments issued on 24 July 2014 is the IASB's
replacement of IAS 39 Financial Instruments: Recognition and Measurement. The Standard includes
requirements for recognition and measurement, impairment, derecognition and general hedge accounting”.
46
appropriate accounting practices and disclosures will enable investors to make informed
and educated decisions.
10. Conclusion
The paper presented the challenges that confront the growth and development of capital
markets in Pakistan in general and derivatives markets in particular. While supply-side
challenges such as lack of product innovation, excessive regulations, difficulties in
transitioning from Badla/CFS to derivatives, and inadequate education and training of the
supply-side market participants are an impediment, demand-side challenges appear to be
more prominent. These include some cultural norms such as low saving rates and therefore
lack of preference for investments in general, inadequate financial literacy among
investors, lack of attractive investment opportunities, low network embeddedness of
investment firms and some accounting related challenges faced by institutional investors.
These norms hinder the development of derivatives markets in Pakistan.
The policy formulation and execution is required to be research-based and must include
both demand-side (investors) and supply-side (brokers and investment firms) participants.
Moreover, financial literacy amongst investors, and education and training of industry
professionals are key determinants of success of capital markets including the derivatives
markets. Confidence building among investors through transparency and accountability,
provision of Shariah-compliant derivatives and improvement in accessibility will also
determine the future prospects of the derivatives markets. Furthermore, enhancing the
liquidity of derivatives and facilitating the provision of sufficient cash liquidity amongst
market participants by balancing margin requirements may motivate retail investors to
invest in derivatives. Encouraging mutual funds and voluntary pension funds to invest in
derivative market within the realm of the investment policies of the clients will contribute
to active and deep markets and will promote liquidity. Lastly, appropriate and clear
accounting procedures related to derivatives, aligned with the international standards for
the institutional clients need to be developed to encourage them to participate on the
organized derivatives exchanges.
With the improving economic and financial outlook of Pakistan, the SECP and the
exchanges have an opportunity to address the current challenges, and proactively
47
introduce products and take appropriate measures to promoting active and transparent
derivatives markets.
48
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52
Institute of Financial Markets of Pakistan (IFMP) formerly Institute of Capital

Markets (ICM) was established in 2009 to introduce professional certification regime in
Pakistan with an objective to enhance the technical and ethical standards of capital market
and insurance professionals. The Institute was established as a ‘not-for-profit company’
and a public sector entity by Securities and Exchange Commission of Pakistan (SECP) along
with key financial market stakeholders:
Pakistan Stock Exchange (PSX)
LSE Financial Services formerly Lahore Stock Exchange (LSE)
ISE Financial Services formerly Islamabad Stock Exchange (ISE)
Pakistan Mercantile Exchange (PMEX)
Central Depository Company (CDC)
National Clearing Company of Pakistan (NCCPL)
Mutual Funds Association of Pakistan (MUFAP)
CFA Society of Pakistan (CFAAP); and
Institute of Cost and Management Accountants of Pakistan (ICMAP)
IFMP is mandated to: (i) certify and train different segments of the capital market &
insurance industry and develop skilled professionals who have full knowledge of legal and
regulatory framework, technical and ethical standards and investor rights, (ii) provide
platform for research and development, and (iii) provide consultancy services on matters
pertaining to capital markets and insurance industry.
IFMP is committed to become the leader in (i) providing high quality education and
training in the financial sector, (ii) emphasising and enforcing high ethical standards and
(iii) a reliable and respected source of knowledge and information in the local financial
community.
53
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Institute of Financial Markets of Pakistan

Derivatives in Pakistan: Challenges, Opportunities and Recommendations

Dr. Hameedah Sayani

Mr. Zafar ul Haq Hijazi

Mr. Muhammad Ali Khan

Mr. Amjad Khan

Mr. Nauman Lakhani

Mr. Sani-e-Mehmood Khan

Mr. Naveed Akber Raja

Mr. Fahad Fahim

Securities and Exchange Commission of Pakistan

1. Derivatives and their Characteristics

Derivatives trade on organized exchanges as well as in Over-the-Counter (OTC) markets

option pays a premium for the right.

2. Functions and Users of Derivatives Markets

3. Overview of Global Derivatives Markets

Figure 1: Regional Contribution in Global Derivatives Trading

Non-Precious Others*, 3.3% Precious Metals,

Currency, 11.2% Interest Rates, Individual Equity,

Source: Futures Industry Association (2016)

Figure 3: Exchange-traded Futures and Options by Location

0 10,000 20,000 30,000 40,000 50,000

6,000 Average Daily Turnover

Figure 4: Global OTC Derivatives Market

600,000 Notional Amounts Outstanding (Billions of US dollars)

Gross Market Value

According to a report published in March 2016 by Market Voice, 28 Asian exchanges

4. Regional Derivatives Markets

Hong Kong Exchanges 189,824,363 142,439,039 33.27%

Source: Futures Industry Association (2016)

figures could not be reported due to unavailability of data.

Table 4: Products Offered at Regional Derivatives Markets

5. Derivatives Markets in Pakistan

Derivatives Markets in Pakistan

OTC1,2,3 Organized Exchanges

Pakistan Mercantile Exchange Pakistan Stock Exchange

Interest Equity Equity

period and confidence level.

Figure 6: Chronology of the PMEX

March 2013 June 2015 October 2015 September 2016

Source: PMEX (2016)

Figure 7: Trading on the PMEX (2009 to 2015)

Value Traded in Rupees Billions

Figure 8: Active Traders and Active Brokers at the PMEX

14,000 UINs [LHS] Active Traders [LHS] Active Brokers [RHS] 80

Number of Active Brokers

Source: PMEX (2015)

Table 5: Historical Average Daily Volume and

15 Data was provided by the PSX data department.

5.1. Regulations for Derivatives Markets in Pakistan

 Approving rules, by-laws and regulations of derivatives exchanges.

The concept of market makers was introduced to promote liquidity in commodities

Table 6: Margin and Guarantee Requirements at the PSX and PMEX

and/or Bank underlying index guarantee and 50% in

TREC Holder as a guarantee in Deliverable Future Contracts and Cash-Settled Futures

6. Determinants of Successful Derivatives Markets

6.1. Characteristics of the Underlying

6.2. Size of the Spot Market