SEBI has appointed a committee under the
chairmanship of Dr. L. C. Gupta in November 1996 to "develop an
appropriate regulatory framework for derivatives trading in India".
In March 1998, the L. C. Gupta Committee (LCGC) submitted its report
recommending introduction of derivatives markets in a phased manner
beginning with the introduction of index futures. The SEBI Board while
approving the introduction of index futures trading put up the setting
up of a group to recommend measures for risk containment in the
derivative market in India. Accordingly, SEBI constituted a group in
June, 1998: with Prof. J.R. Varma, as Chairman.
The group submitted its report in 1998. The group began by enumerating
the risk containment issues that assumed importance in the Indian
context while setting up an index futures market. The recommendations of
the Group as covered by its report are as under:
Estimation of Volatility (Clause 2.1)
Several issues arise in the estimation of volatility:
- The Volatility in the Indian market is quite high compared to
developed markets.
- The volatility in the Indian market is not constant and is
varying over time.
- The statistics on the volatility of the index futures markets
does not exists and therefore, in the initial period, reliance has
to be made on the volatility in the underlying securities market.
The LC Gupta Committee (LCGC) has prescribed that no cross margining
would be permitted and separate margins would be charged on the
position in the futures and the underlying securities market. In the
absence of cross margining, index arbitrage would be costly and
therefore possibly will not be efficient.
Calendar Spreads (Clause 2.2)
In developed markets, calendar spreads are essentially a play on
interest rates with negligible stock market exposure. As such margins
for calendar spreads are very low. In India, the calendar basis risk
could be high due to the absence of efficient index arbitrage and the
lack of channels for the flow of funds from the organised money market
to the index future market.
Trader Net Worth (Clause 2.3)
Even an accurate 99% "value at risk" model would give rise to
end of day mark to market losses exceeding the margin of approximately
once every 6 months. Trader networth provides an additional level of
safety to markets and works as a deterrent to the incidence of defaults.
A member with a high networth would try harder to avoid defaults as his
own networth would be at stake.
Margin Collection and Enforcement (Clause 2.4)
Apart from the right calculation of margin, the actual collection of
margin is also of equal importance. Since initial margins can be
deposited in the form of bank guarantee and securities, the risk
containment issues in regard to these need has to be tackled.
Clearing Corporation (Clause 2.5)
The clearing corporation provides novation and becomes the counter
party for every trade. In this circumstances, the credibility of the
clearing corporation assumes the importance and issues of governance and
transparency need to be addressed.
Position Limit (Clause 2.6)
It can be necessary to prescribe position limits for the market
considering whole and for the individual clearing member / trading
member / client.
Margining System (Clause 3) - Mandating a Margin
Methodology not Specific Margins (Clause 3.1.1)
The LCGC recommended that margins in the derivatives markets would be
based on a 99% (VAR) approach. The group discussed ways of
operationalizing this recommendation keeping in mind the issues relating
to estimation of volatility discussed. It is decided that SEBI should
authorise the use of a particular VAR estimation methodology but should
not make compulsory a specific minimum margin level.
Initial Methodology (Clause 3.1.2)
The group has evaluated and approved a particular risk estimation
methodology that is described in 3.2 below and discussed in further
detail in Appendix 1. The derivatives exchange and clearing corporation
should be authorised to start index futures trading using this
methodology for fixing margins.
Continuous Refining (Clause 3.1.3)
The derivatives exchange and clearing corporation should be encouraged
to refine this methodology continuously on the basis of further
experience. Any proposal for changes in the methodology should be filed
with SEBI and released to the public for comments along with detailed
comparative backtesting results of the proposed methodology and the
current methodology. The proposal shall specify the date from which the
new methodology will become effective and this effective date shall not
be less than three months after the date of filing with SEBI. At any
time up to two weeks before the effective date, SEBI may instruct the
derivatives exchange and clearing corporation not to implement the
change, or the derivatives exchange and clearing corporation may on its
own decide not to implement the change.
Initial Margin Fixation Methodology (Clause 3.2)
The group took on record the estimation and backtesting results
provided by Prof. Varma (see Appendix 1) from his ongoing research work
on value at risk calculations in Indian financial markets. The group,
being satisfied with these backtesting results, recommends the following
margin fixation methodology as the initial methodology for the purposes
of 3.1.1 above.
The exponential moving average method would be used to obtain the
volatility estimate every day.
Daily Changes in Margins (Clause 3.3)
The group recommends that the volatility estimated at the end of the
day's trading would be used in calculating margin calls at the end of
the same day. This implies that during the course of trading, market
participants would not know the exact margin that would apply to their
position. It was agreed therefore that the volatility estimation and
margin fixation methodology would be clearly made known to all market
participants so that they can compute what the margin would be for any
given closing level of the index. It was also agreed that the trading
software would itself provide this information on a real time basis on
the trading workstation screen.
Margining for Calendar Spreads (Clause 3.4)
The group took note of the international practice of levying very low
margins on calendar spreads. A calendar spread is a position at one
maturity which is hedged by an offsetting position at a different
maturity: for example, a short position in the six month contract
coupled with a long position in the nine month contract. The
justification for low margins is that a calendar spread is not exposed
to the market risk in the underlying at all. If the underlying rises,
one leg of the spread loses money while the other gains money resulting
in a hedged position. Standard futures pricing models state that the
futures price is equal to the cash price plus a net cost of carry
(interest cost reduced by dividend yield on the underlying). This means
that the only risk in a calendar spread is the risk that the cost of
carry might change; this is essentially an interest rate risk in a money
market position. In fact, a calendar spread can be viewed as a synthetic
money market position. The above example of a short position in the six
month contract matched by a long position in the nine month contract can
be regarded as a six month future on a three month T-bill. In developed
financial markets, the cost of carry is driven by a money market
interest rate and the risk in calendar spreads is very low.
In India, however, unless banks and institutions enter the calendar
spread in a big way, it is possible that the cost of carry would be
driven by an unorganised money market rate as in the case of the badla
market. These interest rates could be highly volatile.
Given the evidence that the cost of carry is not an efficient money
market rate, prudence demands that the margin on calendar spreads be far
higher than international practice. Moreover, the margin system should
operate smoothly when a calendar spread is turned into a naked short or
long position on the index either by the expiry of one of the legs or by
the closing out of the position in one of the legs. The group therefore
recommends that:
- The margin on calendar spreads be
levied at a flat rate of 0.5% per month of spread on the far month
contract of the spread subject to a minimum margin of 1% and a
maximum margin of 3% on the far side of the spread for spreads with
legs upto 1 year apart. A spread with the two legs three months
apart would thus attract a margin of 1.5% on the far month contract.
- The margining of calendar spreads
be reviewed at the end of six months of index futures trading.
- A calendar spread should be treated
as a naked position in the far month contract as the near month
contract approaches expiry. This change should be affected in
gradual steps over the last few days of trading of the near month
contract. Specifically, during the last five days of trading of the
near month contract, the following percentages of a calendar spread
shall be treated as a naked position in the far month contract: 100%
on day of expiry, 80% one day before expiry, 60% two days before
expiry, 40% three days before expiry, 20% four days before expiry.
The balance of the spread shall continue to be treated as a spread.
This phasing in will apply both to margining and to the computation
of exposure limits.
- If the closing out of one leg of a
calendar spread causes the members' liquid net worth to fall below
the minimum levels specified in 4.2 below, his terminal shall be
disabled and the clearing corporation shall take steps to liquidate
sufficient positions to restore the members' liquid net worth to the
levels mandated in 4.2.
- The derivatives exchange should
explore the possibility that the trading system could incorporate
the ability to place a single order to buy or sell spreads without
placing two separate orders for the two legs.
- For the purposes of the exposure
limit in 4.2 (b), a calendar spread shall be regarded as an open
position of one third of the mark to market value of the far month
contract. As the near month contract approaches expiry, the spread
shall be treated as a naked position in the far month contract in
the same manner as in 3.4 (c).
Margin Collection and Enforcement(Clause 3.5)
Apart from the correct calculation of margin, the actual collection of
margin is also of equal importance. The group recommends that the
clearing corporation should lay down operational guidelines on
collection of margin and standard guidelines for back office accounting
at the clearing member and trading member level to facilitate the
detection of non-compliance at each level.
Transparency and Disclosure (Clause 3.6)
The group recommends that the clearing corporation / clearing house
shall be required to disclose the details of incidences of failures in
collection of margin and / or the settlement dues at least on a
quarterly basis. Failure for this purpose means a shortfall for three
consecutive trading days of 50% or more of the liquid net worth of the
member.
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