Regulatory Tools Key to Market Efficiency

V. Shunmugam, Niteen Jain and Nazir Ahmed Moulvi

(Published in book titled Research in Financial Derivatives by Pondicherry University, India)

Mankinds quest for markets that can meet the challenge of an unpredictable future with limited resources ended up in derivative markets, which provides all the stakeholders equal access to spread their risks thinly into the economy. Until the negative impact of the financial crisis on them was experienced, the boom in the business of exchange-traded marketplaces blinded both regulators and stakeholders in developed economies from possible pressure points that these markets could come under, leading to undesirable impact on the real economy. Post-crisis, regulatory tools of derivative markets have found a renewed attention. Though they are critical to maintaining market discipline and its healthy development, the tools can also be a big hindrance to the normal functioning of markets if not used judiciously. Therefore, a judicious use of an optimal mix of various regulatory tools would not only help these markets to efficiently function but also help effectively serve their stakeholders. Also, real-time, one-point coordination among all regulators at the international level rather than regulation in isolation across scattered geographies maybe the panacea to keep healthy the world of interconnected financial markets. With the progress of civilisation, as humans began specialising in what they produced, markets emerged to transact goods and services among specialising communities (usually located in geographically diverse regions) using a common medium called money a currency note backed by credible public institutions such as treasuries of kingdoms or by governments that have a long history of autonomous existence from mankinds journey from the autocracy that prevailed few centuries ago to the democracy of modern days 1. In the process, much had been left to the players in markets to value these goods and services appropriately assuming that these markets and, hence, the players in them operate in the public interest to fully converge the forces of demand and supply in a fairly competitive situation. However, in reality, in regular market operations, not only the convergence gets limited to the geographical area but also the structural rigidities prevent them from developing into efficient markets. Also with increasing demand (due to population, its income, etc) and limited

V. Shunmugam is Chief Economist and Niteen Jain and Nazir Ahmed Moulvi are Senior Analysts with the Multi Commodity Exchange of India Ltd., Mumbai. Views expressed here are personal.

Kinnaird, Percy Evolution of Money BiblioBazaar, LLC, 2009, ISBN 1113998970, 9781113998972
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Electronic copy available at: http://ssrn.com/abstract=1915116

supplies of resources to satisfy the same, the producers, processors, and those in the supply chain always needed a market place where they would not only know the price in advance but would like to participate and lock in their future cost or return expectations to bring in socioeconomic stability in respective sovereigns. Mankinds quest for markets that can meet the challenge of unpredictable future due to limited resources that would support growing population and its needs ended up in derivative markets that provide equal access to stakeholders to participate and spread the risks arising out of such a situation thinly into the economy. These markets came into being to be accessed by a wide set of stakeholders directly or indirectly, predominantly for trading on the underlying commodities during its early stages of evolution. Later, trading was extended to intangible asset classes such as stocks, exchange and interest rates2. Among these, commodities remain the earliest derivatives market-traded asset class, with derivatives in others which are just about a couple of decades old. Given their economic functions, the benefits they are supposed to deliver to the real economy, the amount of information that

is needed to be converged into the marketplace and its implications on the future state of the economy and its stakeholders, the leverage that they provide to the participants, derivative markets were not only more closely monitored and supervised but were also regulated using varied tools. With the ingraining of the self-correction mode of markets per the capitalistic thinking that prevailed over during the last half a century not only among the regulators but also among the policymakers and all stakeholders of much of the western economies, some of these regulatory tools were sparingly used in few of their markets and few other tools had almost sunk into oblivion. Even, any effort on the part of regulators to use various tools to control market transgressions faced opposition from the participants as being detrimental to the functioning of organized and transparent exchange traded market places. This could partially be attributed to the principles-based regulations as they prevail in US and UK markets compared with the prescriptive rules-based regulations as it exists in the emerging markets. The financial crisis an eye opener Until the recent financial crisis and its impact on the exchange-traded marketplaces, the stakeholders and the regulators basked in the glory of the growth in their regulated exchange-traded markets. Globalization and the free

Swan, Edward J. Building the Global Market, A 4000 Year History of Derivatives Kluwer Law International; First edition (January 1, 2000), ISBN-10: 9041197591

Electronic copy available at: http://ssrn.com/abstract=1915116

movement of capital across developed and a few developing economies further boosted volumes in the derivatives markets of developed economies. The boom in the business of exchange-traded marketplaces blinded the regulators and the stakeholders from possible pressure points in the markets leading to their undesirable impact on the real economy making businesses suffer and, in some cases, the stakeholders withdraw from markets. Evidently though, the US Commodity Futures Trading Commission (CFTC) announced that its enforcement program filed 57 enforcement actions in Fiscal Year (FY) 2010 14 percent more than in FY 2009 and 42 percent more than in FY 2008 (during the height of financial crisis) 3. Thanks to US policymakers realisation about the implications of a lax regulatory policy regime, the senate swung in to tighten the armoury of the regulators of 0US markets. The Dodd-Frank Bill was introduced to address the shortcomings in the regulated markets and the arbitrages that existed between the regulated and non-regulated marketplaces. Though the Bill was welcomed with cautious optimism by most market players, academicians and policymakers came out in its support overtly. On the strength of efforts put in to drafting and finalization of the Bill and support from

academicians, SEC and CFTC, the key regulators of exchange-traded marketplaces for various underlying financial assets have initiated the process of development of comprehensive regulations that will keep away the organized exchange traded market places from any unwarranted public criticism. These regulations are aimed at preventing risks to and from exchange-traded marketplaces from its user stakeholders or on the real economy and its stakeholders. Thanks to the financial crisis, policy makers and regulators across the globe are also looking at a common forum where coordination on regulation could be discussed, ranging from the politically charged G-20 forum to the international institutional forums such as IMF and BIS.

Of risks, derivative markets and regulations

Here is an attempt to look at the basic functions of exchange-traded derivatives markets, risks arising out of their functioning or posed to their efficient functioning and the regulatory tools used to contain them. In doing so, an attempt has been made to collate regulatory tools/practices and ways of their use by various global regulators had been examined in this attempt. Having said, it is notable that regulatory tools in derivatives markets are double-edged swords that can well prove lethal to the normal functioning of markets if not used judiciously. While regulatory

http://forexmagnates.com/cftc-increasesenforcement-filings-by-14-in-2010/

tools/practices would have local cultural or micro-market structure assumptions behind them, in the light of increasing interconnectedness of markets and hence easy spread of information among them, regulatory tools or practices have been examined from their perspective of suitability for the sustenance and longterm healthy existence of exchangetraded derivative markets to deliver its benefits to the real economy. Meanwhile, the inter-connectedness of the derivatives markets for various asset classes and markets across various geographies leaves much for the market participants to arbitrage regulatory regimes4; especially if there exists a disconnect between the business interests of the exchanges as SROs and the regulators besides between regulators of various asset classes and regulators from across the globe. Such conditions further requires that the regulators would not only have to work in tandem with others within their own geography and across interconnected geographies but also have a deeper understanding of the cash and other inter-connected OTC markets. With different regulatory structures that exist across economies, it is also necessary that

Article titled Sen. Dodd Concerned About Global Regulatory Arbitrage, Particularly in Derivatives Area. http://financialreform.wolterskluwerlb.com/2010/ 08/sen-dodd-concerned-about-global-regulatoryarbitrage-particularly-in-derivatives-area.html Accessed on Oct 19, 2010.

there exists a global forum wherein issues related to financial stability arising out of the exchange traded derivative markets, functioning of the financial sector, and its implications for the real economy could be discussed and ironed out. Such a forum could also be replicated at the national level to ensure coordination at the local level among regulators across various asset classes and the central banks before issues could be examined at the global level. The recent establishment of Financial Stability Development Council through an executive order of the Government of India signifies the same in favour of a body for inter-market coordination within the Indian economy. It could apply well to economies with the varied regulators in the financial sector with markets that are interconnected in terms of participants. Even, within those nations adopting a single regulator model for the financial sector, this signifies the need for increased coordination among different arms of the regulators looking into various asset classes and at times the underlying cash markets by making formal structure for the same to function under given principles along with the central bank as the pivot. Keeping this aside, issues in inter-market and interglobal institutions have been highlighted in the paper for appropriate cooperation and coordination among them to help resolve problems in market irregularities at their origin.

Exchange Traded Derivatives markets Roles, Risks and Regulations

During the last three decades, derivatives have developed into an important class of global financial instruments that are central to the existence of the transparent and exchange traded market places helping economic stakeholders manage their risks in an era of rapid information flow. By being transparent, and regulated, exchange platforms in which these derivatives are traded were also expected to provide advance signals to policy makers to help them effectively decide on policies for economic stability and hence social and political stability. Simultaneously, the opaque and OTC traded market places that have catered to customisation needs of market participants also remained no stranger to innovations in financial derivatives5, the only difference being unregulated innovation leading to the development of complex derivative products often to the benefit of their originators6 rather than

Article titled OTC Derivatives Don't Need Fixing by Menachem Brenner. Accessed on Oct 19 2010;

http://www.forbes.com/2010/05/11/financeregulation-derivatives-opinions-contributorsmenachem-brenner.html
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Steven L Schwarcz, Rethinking the disclosure paradigm in a world of complexity (University of Illinois Law review Volume 2004). http://www.securitization.net/pdf/content/Schwar cz_Rethinking_04.pdf

end-users. This is proven by the fact that no other class of financial instruments had experienced as much innovation as OTC derivatives as a class. Product and technology innovation, together with competition, had led to a noticeable growth in the exchange-traded derivatives segment as well. Electronification, leverage as it exists in the derivatives market, and the robust clearing mechanisms had not only provided easier access across asset classes to a wide range of participants but also had its own costs and benefits. However, benefits of public regulation and transparency of a market place always outweighed the risks in the case of the exchange-traded derivative segment. On the other hand, over a period of time, these benefits seemed to have overwhelmed the regulators from the potential risks arising out of individual or collective irrationality of participants and, hence, the risks to and from the exchange traded market places. This led to the gradual slackening of regulatory policies across market places, especially in developed markets. An attempt has been made here to look through the possible effects of individual or collective irrationality, its impact on the basic functions that exchange-traded derivatives are supposed to perform in an economy and the role of regulatory tools from an inter-asset class and crossgeographic perspective.

Any text book on derivative markets would tell us that exchange-traded derivatives primarily perform two roles: (1) Price Discovery Discovering prices or exchange rates or yields on bonds in advance through collective expectations of participants (2) Price Risk Management- Allowing economic agents to participate on their platforms to lock in their cost or return expectations to help provide price stability to its consumers.

markets for the underlying asset class. Businesses and individuals are able to manage their risks in a cost-effective way and the risks spread as thinly as possible within the economy. Reduces market instability and, hence, financial, economic, and political instability.

While the risks in derivatives markets can be further segregated, which have been detailed in a number of papers, little has been said of the many regulatory tools used by these markets that aim to control any aberrations in the functioning of these markets caused by instances such as individual/collective market irrationality. Therefore, in this paper we tried to examine in detail the role played by regulators and the tools employed in selected derivatives market spread across the globe (in both developing and developed markets) and also across the asset classes (commodities, securities, currencies, etc) and churn out the regulatory best practices which would make the best use of these double-edged tools. Provided below is a graphical representation of the functions of the derivatives market. We then illustrate the risks that can arise in the way of market efficiently delivering its functions. This is followed by a look at the tools that are available with the exchanges to eliminate such risks.

An independent or a government regulator always supervised and regulated the exchange traded market places so that they function perfectly to perform its functions flawlessly and that their working does not impact the real economy in ways they are not intended to. In a nutshell, regulation in exchangetraded markets makes sure that: Prices discovered for future delivery of the underlying are best reflectors of the future situation as it would prevail in the cash

Risks to and from Derivatives Markets

Derivatives Regulation Worldwide and across Asset Classes

Globally, across the asset classes, to prevent the conversion of potential risks into actual risks, regulations on exchange-traded derivatives trading are first imposed at the exchange level i.e. by exchanges themselves, acting as selfregulatory organisations to ensure integrity of the respective markets. At the next and external level, regulations are levied by an independent regulatory body i.e. a derivatives market regulator. In some countries, an association of market participants, such as the National Futures Association (NFA) in the US, also plays a self-regulatory role to regulate and

monitor intermediaries and market infrastructure institutions with regard to their adherence to regulations. And in others, the quasi or governmental regulatory agencies set the rules for play in the markets and watch the markets from a distance for appropriate action when it perceives risks from it or to its functioning. Table 1 gives a peek at various regulatory bodies and exchanges regulating the derivatives trading in commodities, currencies and securities in some developed as well as developing economies which are being examined to provide a comparative view of regulatory tools for various asset classes and that of various regulators.

Table 1: Regulators and exchanges in derivatives trading worldwide and across asset classes
Asset class Country Commodity (Non agri) Commodity (Agri) Currency US US US Exchange CME CME CME Developed Economies Regulator CFTC CFTC CFTC Country Japan Japan Korea Exchange TOCOM TGE KRX Regulator MITI MAFF FSS Country India India India Exchange MCX MCX MCX-SX Developing Economies Regulator FMC FMC SEBI & RBI Country China China Brazil Exchange SHFE DCE BM&F Regulator CSRC CSRC CVM

Stock US CME CFTC Japan OSE JFSA India NSE SEBI China CFFEX CSRC Index Note the above table shows one of the exchange operating in its economy, however there could be other exchanges as well. CME Chicago Mercantile Exchange; CFTC Commodity Futures Trading Commission; TOCOM Tokyo Commodity Exchange; TGE Tokyo Grain Exchange; KRX Korea Exchange; FSS Financial Supervisory Service; OSE Osaka Stock Exchange; MITI Ministry of International Trade and IndustryMITI; MAFF Ministry of Agriculture, Forestry and Fisheries; JFSA Japan Financial Services Authority; MCX- Multi Commodity Exchange of India; MCX-SX MCX Stock Exchange; NSE National Stock Exchange; FMC Forward Market Commission; SEBI Securities Exchange Board of India; RBI Reserve Bank of India; SHFE Shanghai Futures Exchange; DCE Dalian Commodity Exchange; BM&F Bolsa de Valores, Mercadorias e Futuros; CVM Comisso de Valores Mobilirios; CFFEX China Financial Futures Exchange; and CSRC China Securities Regulatory Commission

The severe global financial crisis of 2008-2009 has put derivatives regulation a hot subject of talks, debates and conversation in various economic, regulatory and market circles across the globe. It became a topic of discussion even in the international bodies such as G-20, etc. Moreover it is the OTC derivatives markets, which are often beyond the conventional regulatory framework, that have come under intense scrutiny of policymakers owing to

lingering doubts of transparency and risks in OTC derivatives markets. Interestingly, it was the counterparty defaults in CDS OTC markets in the US that triggered the collapse of large financial players in the past crisis that led to severe stress throughout the global financial system. In lieu of inherent weakness and lack of regulation in OTC market, the exchange trading platform placed under regulatory framework, guarded by a central clearing house to

counterparty default risk, got viewed as a more competent and efficient alternative to the OTC platform for derivatives trading. Hence, among the policy circles in countries with predominant OTC markets have pushed for trading OTC products on exchange traded platforms or at least through clearing houses (to start with) to mitigate possible counterparty risks and to bring in transparency about looming risks in the markets for appropriate policy mitigation. Notwithstanding, the prime reason behind these calls are the efficient regulations that have been enforced by the regulators on the exchange traded derivatives and the robust clearing mechanism that tackles counterparty risks. This is not to mention that exchange traded markets were beyond public scrutiny, thanks to the commodity market volatility and oil market volatility in particular, exchange traded derivative markets are also being looked into by various regulators looking to strengthen both their price discovery mechanism and the risk management efficiency. Regulatory practices on the overall seem to converge among the developing nations and developed nations but keeping them poles apart regarding the existence of it or the use of it in their respective exchange traded markets. The process of globalization created a new set of asset classes which are global to be traded in both the markets to discover the local prices discounting for both the global and local fundamentals. Thanks to opacity in the developing markets and wider participation in developed markets, there existed not only a wider divide in regulation of markets till financial crisis but also that none complained about the markets in developed economies or their regulation. As the crude prices skyrocketed, it prompted policy makers

to ponder upon issues related to it. It resulted in the debate of regulatory divergence in global market places and the need for a global mechanism that can work not only to bring about convergence but also to provide a platform for ironing out issues raised by respective national stakeholders. For example, any attempt to use such tools as it existed in the past or as it is followed elsewhere were criticised by market stakeholders as being retrograde to the healthy functioning of the derivatives markets. To quote, the recently proposed CFTC rule on the enforcement of position limits in exchange traded US commodity derivatives market had created a uproar against it among the participants in the US commodity markets. Interestingly, such limits have already been in practice in commodity derivatives market of developing countries for reasons other than the purpose of efficient price discovery as developed nations in most of the global asset classes are price takers. Detailing the various regulatory models in different nations across the asset classes or more specifically detailing the scope and variety of various regulatory tools employed by the different regulators presents an interesting compare and contrast case on the regulations across different economies. Hence, on similar lines, regulatory tools across various global exchanges and asset classes are detailed down in the paper. As we examined this area of regulatory tools and practices, dearth of literature substantiating the existence or their use amazed us. But the vast differences among the developed and developing nations made it curious to understand it from the perspective of potential interconnectedness of the markets and hence the need for global convergence in regulation of derivatives industry besides

highlighting the same for further research in academics.

Regulatory Tools Addressing Risks to/from Derivatives Market 1. Margins

Margins on derivative contracts play two potential roles: one, protect against defaults in fulfilling positional obligations and two, provide a vehicle for regulating volume, open interest, and price behaviour (Tomek, 1985) 7. Derivatives are leveraged instruments but offer returns equivalent to those of trading in the cash market as the underlying asset prices move up and down. Thus, higher leverage incentivizes traders to keep markets noisy. Noise in the derivative market beyond limits not only becomes unhealthy for the market itself but also starts impacting the underlying cash market and, in turn, the interests of real economy stakeholders at large. It makes a case for regulating leverage to reduce not only unwanted noise but also financial risks in the derivatives market. This is where the role of margin both initial and mark-tomarket (MTM) margin mechanism comes into play (the role of MTM will be explained later). Leverage is also a mechanism that helps markets gather information by making participation less burdensome and make

participants feel its expected impact in the most disaggregated manner, spreading the risks thinly among the participants (stakeholders). It necessitates that regulators manage leverage carefully and not strangulate markets from efficiently performing their task of widening participation - collection of information related to the fundamentals of the underlying asset class information driven discovery of prices as well as spreading the risks arising out of information entering marketplaces thinly across various (heterogeneous) economic stakeholders. In a nutshell, sterilize the underlying asset class ecosystem of risks by spreading it across to others who are willing to share in return for the information that they are passing into the markets. Margin requirements are used only as a mechanism to prevent a trader from defaulting, and adjusting the margins for the market risk has no impact on trading volume (Phylaktis and Aristidou, 2008)8. Likelihood of a default due to margin violation is a decreasing function of the margin deposit and an increasing function of the price limit. A safe system would be the one that places the price limit higher than the margin deposit so that the margin deposit covers both the price change and a possible further adverse movement of the fundamental

Tomek, William G. Margins on Futures Contracts: Their Economic Roles and Regulation, the American Enterprise Institute for Public Policy Research, Washington, D.C.

Aristidou, Antonis A. and Phylaktis, Kate, Margin Changes and Futures Trading Activity: A New Approach (January 1, 2008). Available at SSRN: http://ssrn.com/abstract=1084104

value unknown because the market is closed (Longin, 1999)9. As margins reflect the leverage that the derivative market provides to its participants, margins are adjusted to reduce the leverage thereby reducing incentives for creation of undue noise. Since margin is pre-announced per the derivative contract at the time of its launch in market place, whatever interim margins levied would be in addition to the initial margin as announced per the contracts traded in the respective exchanges. The exchanges as Self Regulatory Organizations (SROs) have varied these margins per their perception of noise or its measurement using VAR (value at risk) methodology. While in some markets (mostly in emerging economies) margins are leviable from both the sides by both the exchanges and their regulators, in most markets, worldwide, margins are managed mainly by the exchanges based on their own risk perception as SROs. In the event of the contracts with same or similar underlying asset trading on two exchange platforms based in different geographies, it leaves regulatory arbitrage to be exploited in this world of financially interconnected markets. Participants would shift from a highmargin platform to a low-margin platform, thereby defeating the very

purpose behind the use of margins as a regulatory tool to contain market volatility provided the participation cost remains the same. In such cases, it is desirable that regulators intervene to narrow down/close the arbitrage arising out of differential treatment of the same risk by different exchanges trading on identical/similar products. Also, longer the derivative contract gets traded, wider and deeper participation is needed to make information converge in discovering the price while efficiently delivering on its risk management function. At times, it also happens across geographies wherein exchange-traded market places have identical/similar products and are regulated by their respective regulators. In such cases, it warrants that there is a coordinated action in the market place so that market participants do not seek ways around regulatory requirements and, thus, defeat the overall objective behind use of this regulatory instrument. CFTCs recent attempt to reduce the leverage in foreign exchange trading is a clear case wherein the regulator is looking at reducing the leverage in response to the volatility in the markets post the recent financial crisis and the threats it posed to the real economy. Though it is a calibrated measure to tame risks to real economy and to achieve financial stability, if not followed by other markets where the participants can easily shift such as to a currency trading platform in the UK keeping at bay the original intent of the regulators to reduce volatility in the currency markets. Not

Longin, Franqois M. Optimal Margin Level in Futures Markets: Extreme Price Movements. The Journal of Futures Markets, Vol. 19, No, 2. 127152(1999).

only that US markets would lose the price setting power to UK spot currency market but also that the undue volatility that the regulators wished to curb could ever never have been achieved as the UK spot currency markets increased volatility would spread the same to the US markets. It emphasizes that among regulatory trajectories across markets in which similar products are being traded, there needs to be close coordination in regulation between the geographies and among the cash, derivative and other type of regulated exchanges. With the US having a long history of commodity futures, US exchanges have

graduated to level where participants are classified based on their commercial and non-commercial interest. Subsequently, the exchanges charge differential margins to their members. For example, speculators are asked to deposit higher margins than hedgers (see table 2). Offering this incentive of a lower transaction cost to hedgers helps the exchanges attract the hedge interests on to the exchange platform. On the other hand, imposition of higher margins on speculators helps keep tab on speculation. Leverage provided to trade on exchanges is lower in developing countries than that of the developed countries.

Table 2: Margining (Initial margin/lot) and leverage in futures contracts across markets and asset classes Nation Parameter Non-agri commodity Agri-commodity Currency Stock Index Speculator $5063; Speculator: $2700; Speculator - $4,050; Speculator: $28,125; Margin hedger $3750 hedger $2000 hedger $ 3,000 hedger :$22,500 US Speculator -1:14.8; Speculator -1:18.5; Speculator - 1: 40.35; Speculator - 1:10; Leverage hedger 1:20 hedger - 1:25 hedger - 1:54.47 hedger - 1:12.5 $3520.0 $ 4000.0 per UK Margin lot NE NE 3,200 Leverage 1:21.3 - 1:18.7 NE NE 1:17.5 Clearing Margin - JPY Margin 150,000 JPY 27,000 NE JPY 390,000 Leverage 1:26.6 1:16 NE 1:24.6 Japan Member - 3%, Margin NA NE Customer - 4.5% NE Speculator -1:22.2; Leverage NA NE hedger - 1:33.3 NE S Korea Margin 8% 5% NE 12% Leverage 1:12.5 1:20 NE 1:8.3 China Margin NE NE BRL 10,340 NE Leverage NE NE 1:8.4 NE Brazil Margin 5% 5% 1.75% 10% Leverage 1:20 1:20 1:1.57.1 1:10 India Note: The commodity underlings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soybean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlings in the exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively. NE: Not Examined Source: Exchanges websites

Low leverage in developing countries can be due to the fact that in developing markets, political and policy interests exert more control on exchanges to keep a check on prices compared to developed countries. Developed countries provide higher leverage to attract international participation. Margins in the US, the UK, Japan, etc are set on absolute terms on individual contract basis, while developing countries levy margins on the percentage value of contracts. The advantage of applying margins on the percentage value of a contract size is that the margin increases or decreases with a rise or fall in the price of the contract thereby keeping the leverage at the same level. Thus, the relative increase in margin along with either a rise or fall in the price of the contract acts a deterrent for speculators to push up or pull down the prices, for their own profits. Different asset classes compared, the margin requirement for currency derivatives is the lowest as the price variation in currency derivatives is very low. The leverage on currency futures is on the higher side, in both developed and developing countries, as currencies have become global commodities and there arise the need for widening of participation and convergence of as much information as possible. Trading in a particular countrys currency takes place in many other countries across the world. This means if in a given market trading is suppressed by increasing margins, it will lead to export of this domestic market trade to overseas markets.

A Tale of US FX Markets HighLeverage Cash Vs Low-Leverage Derivatives Forex cash markets in the US, which recently came to be regulated by CFTC, have a higher leverage (despite the recent intervention by the regulator) or in few cases a similar leverage compared with their derivative counterpart. It essentially defies the logic that the market which is supposed to transact the underlying (not risks) should have a relatively lower leverage compared with the market which is expected to attract wider participation to efficiently discover the future exchange rate that could help converge as much information as possible and also help the participants transact risks in a most cost-effective way. As both the markets are supposed to clear daily, preventing accumulation of financial risks cannot remain the justification for providing one market with a higher leverage compared with the other market. A reduction in the leverage for the cash FX markets and/or a gradual increase in the leverage of the FX derivative markets would help the markets effectively serve the objectives for which they exist and take better advantage of their coexistence. However, it has the potential to lead to same bargaining point for the US spot forex industry that the US commodity derivatives industry rallied upon i.e. participation could spill over into other geographies and that the US markets would turn into being price takers than be the price setters as they are presently. Taking a step further if the regulators for various markets and

geographies closely coordinate with each other to close down the regulatory arbitrages that might exist and learn from each others regulatory experience, it would help nations coexist with stable economic and business conditions and trade environment thereby supporting and sustaining the ongoing process of globalization than for them to quietly end up in markets to manage their currencies leading to the trade tussle as was the situation during late 2010. What is much visible in todays currency markets regulation could occur in other markets also as the derivative and spot markets integrate leading up to global economic integration. In addition, weak and uncoordinated policy of margining as it exists in the currency markets worldwide (especially so in the spot markets which have an immediate influence on the rates) could also lead to undue growth in markets keeping them away from ability of the government for intervention even if they were to notice collective irrationality in the market. Exactly the same occurred in the Japanese Yen (JPY) markets wherein the JPY strengthened much in the last six months as the corporates, exporters and the governments could only watch it helplessly except for one bout of intervention by the Japanese government. Companies/exporters and government could only make statements in the press about the unhealthy rise of JPY but not do anything about it. Hence, only a better coordination and cooperation among the national regulators themselves and those in various geographies and the

effective use of regulatory tools such as this on controlling leverage by the exchanges and regulators can only prevent this. Can IOSCO or G-20 be the forum wherein the national regulators could synergistically work together? This could perhaps be better discussed after having an understanding of other un/related regulatory tools that exist in the in the world of markets for futures in a range of asset classes. Financial Insolvency Risks and Role of Mark-to-Market Margins While the risk of higher volatility is a risk faced by the real economy wherein the contagious nature of derivative market price behaviour could spill over to spot markets thereby transforming price risk into risk premiums in the supply chain. Trading in derivative markets also pose risks to the market, with the risk of financial insolvency arising out of undue volatility in prices and the risk of not being able to receive or provide deliveries by hedgers who intend to do the same. As positions in a derivative market could remain open for few seconds to few months or few years depending on the length of the contracts and the participants need for risk management, the price of the underlying at any point of time would have changed drastically from the price at the time of entry. It requires that depending on entry and the respective notional exit position (last traded price of the same contract) at any point of time (that the market player would have to take to close down their

positions) should be monitored per the prevailing market conditions to prevent financial risks from accumulating in the derivative markets. The risk of accumulation of financial risks in this market is being avoided by the derivatives markets themselves or their clearing houses through another type of margin namely, mark-to-market margin which is monitored on a real time basis for deficits to be collected before it exceeds the security deposits of the member/traders held by the exchanges. While the MTM margin concept exists across exchanges and asset classes, its use in a real situation varies across exchanges and asset classes. The effectiveness of its use on financial risk management by the exchanges would depend on whether there exists a daily price band beyond which losses cannot increase, the kind and the amount of security deposits collected by the exchanges, the extent of anticipated volatility in the prices of underlying positions, etc. In addition, the recent electronification of the markets has not only provided for an opportunity of realtime monitoring of notional profits/losses by the participants but also enabled the exchanges to pre-warn the traders of their margin utilization against the notional losses that have been accumulated till that time on a netted market-wide position basis. Such warnings as provided by the exchanges make markets not only participant-friendly but also risk-proofed. MTM The need for organized clearing of CDS markets

Discussions about the goodness of MTM margining practices of exchange-traded derivatives markets came to the fore during the recent global financial crisis caused by OTC derivatives such as CDS (credit default swap) and CDO (credit debt obligation). Being privately negotiated contracts, these OTC derivatives neither had a defined margining system (security deposit) nor were marked-to-market every day to be cleared by an approved clearing house. When the crisis emerged, the holders of these instruments did not know exactly the worth of the CDO/CDS assets being carried in their books and hence they tended to accumulate losses beyond their ability. Had these contracts been markedto-market and the financial risk cleared on a periodical basis, as followed by exchange traded derivatives markets, not only that the risks would have been better contained, but also advance signals of this impending crisis, would have been sent out for appropriate policy making before bubbles could grow into cataclysmic proportions. It would also have made the market participants to incorporate this risk into the pricing of CDO/CDS that they were trading on. In the absence of an effective MTM margining system, there always existed a large default risk (both financial and delivery) warranting a chain reaction in markets not necessarily due to their interconnectedness but because of participation of the same set of traders across the board in most asset classes. In short, MTM margining prevents exchanges from financial defaults of its

participants and hence preventing its cascading impact on the rest of financial sector as it happened in the case of Lehmanns collapse. Similarly, an additional delivery period margin in case of deliverable derivatives contracts helps the derivative market cover the risk of delivery failure (Smetters, 2010)10. Markets will achieve an ideal state, in terms of their own risk management, if the asset classes are made ideal to be traded on transparent electronic exchange-traded markets and profits and losses are tracked on a real-time basis against the collateral held by the participant in the clearing house; MTM profit/losses are debited or collected on a daily basis to prevent accumulation of risks beyond a day and, thus, enable participants to assess their risks based on their fund availability, risk management needs, risk bearing ability, and future price or return expectations based on the fundamentals of the asset classes than the animal spirits. The price at which markets settle on a daily basis varies from market to market. Developed countries such as the US and the UK and many developing countries, including India, follow SPAN margining system for calculating MTM. Thus, overall, exchanges have their own systems of calculating their daily close based on
10

volatility in prices and market- wide risk expectations. Unlike exchange-traded standardized derivative contracts, overthe-counter (OTC) derivatives are customised bilateral contracts between buyers and sellers, and are not traded on exchanges. So, market prices of these instruments are not established by any active and a regulated market trading in them. Market values in the case of OTC derivatives are, therefore, not objectively determined or readily available. Therefore, they are difficult to be marked-to-market.

2. Price Limits Tackling the Herd Behaviour

Volatility in the price of the underlying is an indicator of risks that could potentially accumulate to be reflected in the spot market over a period of time resulting in gravity-defying prices of the asset class. Particularly, if the volatility is the result of a spill-over from the overlying derivative markets, it would be of concern to both policymakers and regulators. Yet another way in which derivative markets have been used to contain the financial risks is by fixing a price band, called price circuit filters in markets technical parlance or price limits in the general global parlance. If in line with the historical cash market trends i.e. historic price volatility seen in the cash markets, it would remain a tool to prevent the contagion that a loosely regulated derivative market would otherwise create in the underlying cash market. By virtue

Kent Smetters, professor of insurance & risk mgmt at Wharton Regulating the Unknown: Can Financial Reform Prevent Another Crisis? http://www.knowledgeatwharton.com.cn/index.cf m?fa=viewfeature&articleid=2245&l=1&&&lang uageid=1

of price limits, extreme price movements associated with panic or excessive speculation is restricted to the average level the same information would have created in a cash market and thus helping in curbing undue one-way movement in prices in a futures markets. Flash Crash of 2010 and Importance of Price Limits the

The recent infamous May 6 flash crash in the US equity market is a case in point that underscores the importance of price limits. On May 6, Dow Jones Industrial Averages sudden drop of nearly 1,000 points that erased $862 billion from the value of equities in less than 20 minutes that rattled US investors confidence, could obviously have been averted had there been appropriate price limits in the underlying stocks. Understandably now, many exchanges that have earlier dismantled this instrument of risk management, are now reportedly contemplating to introduce them. From September 27, 2010, Brazils BM&F Bovespa introduced price circuit breaker that stops shares, ETFs, and other assets traded on the spot market from deviating more than 15 percent of the previous days closing price. Price limit is best fixed if it closely resembles the price behaviour as it would exist in the cash markets of the respective underlying asset classes. A price limit so fixed serves the dual purpose of preventing trades from happening at prices at a higher percentage movement than that is allowed on an exchange platform as the trade is stopped for some

time and provides an opportunity to indicate to the market participants that there is something fundamentally wrong in their price discovery process thereby providing them an opportunity to correct themselves when the market opens. It also prevents the herd behaviour that exists among many who overlook the fundamentals. The findings of Anthony Hall and Paul Kofman (2001) 11 conclude that price limits help control contract default risk and, thus, reduce required margins and, in turn, cost of transaction. A lot of research has been conducted on the impact and utility of price limits. From all these studies which have attempted to examine the impact of price limits one can safely conclude that the benefits derived from imposition of price limits far outweigh the perceived shortcomings of this tool. The existence of price limits in certain futures markets is explained by way of demonstrating that price limits may act as a partial substitute for margin requirements in ensuring contract performance (Brennan, 1986)12. The size of margin is negatively correlated with the extent of price limits. Empirical results cast doubt over the notion that price limits be abolished

11

Hall, Anthony D. and Kofman, Paul (2001). Regulatory Tools and Price Changes in Futures Markets School of Finance and Economics University of Technology, Sydney
12

Brennan, M. (1986), A Theory of Price Limits in Futures Markets, Journal of Financial Economics, 16, 213-233

(Chen, 2002)13. Price limits enable traders to better meet variation margin calls by giving them time to raise funds, and by making more predictable the amount of cash they may need during any given period of time. Ackert et al (1994)14 were of the view that price limits decrease the margin that brokers and exchanges require since the amount of risk they bear under a system of price limits is smaller than the amount that they would incur if prices were completely unconstrained. Longin 15 (1999) Imposition of a bottoming price level (to support producers) or a topping price level (to protect consumers) can reduce market price volatility. However, price limiters influence the price dynamics in an intricate way and may cause volatility clustering (Hea and Westerhoff, 2005)16. The findings of

13

Chen, Haiwei (2002) Price Limits and Margin Requirements in Futures Markets The Financial Review 37 (2002) 105--121
14

Evans and Mahoney (1996)17 on impact of price limits on New York Cotton Exchanges cotton options contract show that when price limit is imposed, volume in options contracts decreases compared with the absence of price limits. At the same time, aggregate volume in futures and options contract remains the same when price limit is imposed, which indicates that market participants react rationally to the price limit in the futures market by transferring their trading activity to a market without price limits and that in a market without price limits, participants prefer options than futures. Constraining prices reduce the probability of contract repudiation resulting from unfavourable price movements and, thus, lowers risk. Markets often witness large swing in prices (possibly due to overreaction) and price limit as a tool of risk management helps cool down the market. It helps in avoiding the formation of speculative bubbles dampening the chances of financial crises (Fernandes and Rocha, 2007)18.

Ackert, Lucy F.; Hunter, William C. and Laurier, Wilfrid, Rational price limits in futures markets: tests of a simple optimizing model. Review of Financial Economics Volume 4, Issue 1, Autumn 1994, Pages 93-108. 15 Longin, Franqois M. Optimal Margin Level in Futures Markets: Extreme Price Movements The Journal of Futures Markets, Vol. 19, No, 2. 127-152(1999)
16

17

Evans Joan & Mahoney James M., 1996. "The effects of daily price limits on cotton futures and options trading," Research Paper 9627, Federal Reserve Bank of New York.
18

Hea, Xue-Zhong and Westerhoff, Frank H. Commodity markets, price limiters and speculative price dynamics Journal of Economic Dynamics & Control 29 (2005) 15771596

Fernandes, Marcelo and Aurlio Dos Santos Rocha, Marco, Are Price Limits on Futures Markets that Cool? Evidence from the Brazilian Mercantile and Futures Exchange (Spring 2007). Journal of Financial Econometrics, Vol. 5, Issue 2, pp. 219-242, 2007. Available at SSRN: http://ssrn.com/abstract=1145513 or doi:10.1093/jjfinec/nbm001

Nation

Table 3: Price limits in futures contracts across markets and asset classes Non-agri commodity Agri-commodity Currency Stock Index
In steps of $10/barrel with trading halt of 5 minutes each time No limits In steps of JPY 2,400/kilo litre upto 3 times NE 5% $0.70/bu, expandable to $1.05 & $1.60; no price limits in spot mth NE 1,800 JPY per lot NE 6% in spot mth & 4% in subsequent mth NE 3 + 1% with 15 min interval No limits NE NE 4.50% NE No limit for last three days of expiry mth; 5% for other contracts2 For contracts tenure upto 6 mths: 3% of base price; others 5% RTH: 10%, 20%, 30% limits (downside); ETH: 5% up/down1 16% NE 10%

US UK

Japan S Korea China

NE

NE

Brazil
4% + 2% + 3%3

10%

India

Note: Commodity underlyings in exchanges across nations for the non-agri sector: crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlyings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively; NE: Not Examined 1: RTH Regular trading hours; ETH Extended trading hours; 2: Maximum daily price fluctuation 5 % on the previous days settlement price of the traded month. The price fluctuation limit for the first month shall be suspended on the last three days of trading; 3: On MCX, the price circuit filters are expanded from (4+2)% to 9% after a cooling off period of 15 minutes; Source: Exchanges websites

Under the current market environment wherein both human beings and programmed machines participate in financial markets, clashes are obvious. In trade, humans put in their psychological, statistical, emotional and rational decision-making skills, whereas machines are programmed to take decisions under a given set of conditions. Unlike human behaviour, machines restrain from reacting when a market behaves beyond the artificial intelligence that they are coded for. The May 6, 2010 crash was found out to be the result of programmed trading failing to think beyond the codes, in a rational manner unlike a trained human brain. Such an unattached behaviour of the machines

multiplies the emotions of human participants in the markets leading to events like flash crash. Overcoming a situation like this calls for putting a brake on the financial system when machines or humans follow each other in a panic situation accentuating price movements. It is in this context price limits become more relevant. When the price of a derivative contract moves unidirectional, price limits put a temporary halt on trading, providing an opportunity to the panicky crowd to rethink before moving further. Compared to generally stringent price limits across asset classes in the eastern economies, the western economies have comparatively

relaxed price limit (with the UK having absolutely no limits). Notably, the CME (US) in agri futures and B&MF (Brazil) in currency futures provide ample opportunity for price discovery in the final phase of the contract (spot month), without enforcing any price limit. On the other hand, emerging nations like India and China have differential price limit system for currency and agri futures respectively depending on the maturity of the contract month (see table 3). While China follows western counterparts practice of having relatively relaxed price limits in the spot month, Indian exchanges regulation impose a tighter price band in the near months. Considering that there are always possibilities of price manipulations in the near-month contract and it would have direct impact on the underlying markets, the approach of much tightly regulating price limits seems to be risk-averse while allowing for information to converge into the markets. An overarching aspect of price limits that are levied in markets under comparison in the paper is that while developed nations like the US and Japan set price limits (commodities) in absolute terms as like their margin which are also set in absolute terms, emerging nations follow a uniform policy of percentage price limits across asset classes. Also, with the market getting more and more dynamic, it is essential for regulators to dynamically alter price limits. In this context, though regulators, along with exchanges, in India, the US and some other countries act dynamically in response to changing market

conditions, daily price limits in Japan are decided only at the meetings of exchanges board of directors that are conducted quarterly.

3. Position Limits
An efficient market is the one that has a balanced and healthy mix of both commercial and non-commercial participants. While commercial participants participate to hedge the price risk that arises from their physical market positions, non-commercial participants trade purely for profits. For the latter, volatility is the key as their profits come from volatility (anticipated price movements). In quest of profits, noncommercial participants have the potential to escalate volatility by building up large positions in the market sometimes unilaterally and sometimes in conjunction with other traders, thereby jacking up prices far above what the underlying fundamentals would justify. Therefore, the unregulated building up of price volatility in the derivatives market poses a serious threat of price manipulation, which affects efficiency of the price discovery processone of the two most critical functions of the exchange-traded derivatives market. To counter the risk of price manipulation (possibly by way of building up large positions in markets), a regulatory tool widely used by exchanges and regulators worldwide is known as position limits i.e. limit on a participants position. Imposition of position limits on commodity futures curbs excessive speculation and, thus, manipulation

(Ebrahim, 2010) 19. Importantly, acknowledging the differentiation in the role of members, proprietors and clients, generally position limits are variedly imposed on the nature of participants. Notably, position limit deters concentration of positions and spreads liquidity among heterogeneous participants with diversified price views. In this context, a financial market incident of 1998 would make a relevant read. A small group of experts gave the market jitters as their company, LongTerm Capital Management (LTCM), collapsed, losing US$4.5 billion in just a couple of months. What a probe into the incident found as the primary reason behind the fall of LTCM was irrational over-exposure to an illiquid asset class Danish mortgage bonds. Over-exposure was possible as there was no restriction on product portfolio and too much of borrowed money was used for high market exposure, as there was no restriction on exposure. Inference: had there been effective regulation, such as a limit on maximum allowable position in a particular asset class, on the functioning of LTCM, the disaster could have been converted into an unfortunate incident. In a recent development, US President Barrack Obama, on July 21, 2010, signed

the Dodd-Frank Wall Street Reform Act into a law to reform the regulatory system in the country and to implement restrictions. Accordingly, various regulatory changes within the financial services industry aim to impose position limits in commodity derivatives across both futures and OTC positions. But it is obvious that in absence of such initiatives throughout the world in unison, there are serious and realistic apprehensions that imposition of position limits in isolation (in some given economies) will drive the trade volume of more stringently regulated markets to unregulated or less stringently regulated markets. And, this will not only shift price setting power of a market place by shifting the volumes into the unregulated market but also do not serve the intended purpose. Position limits help prevent market abuse which is otherwise possible for a limited number of large and powerful participants. In the spot month, as a risk management measure the limits are set thinner to control chances of any price manipulation, because when a futures contract nears expiry its liquidity declines. Genuine hedgers in all the countries and exchanges analysed above are given exemptions on submission of adequate proofs of underlying commodities exposure. Exchanges in countries analysed, as in table 4, impose position limits, in varying degrees, except the Intercontinental Exchange (ICE) in the UK.

19

Ebrahim, Muhammed Shahid, Do Position Limits Curb Futures Market Manipulation? A Simple General Equilibrium Explanation (August 30, 2010). Available at SSRN: http://ssrn.com/abstract=1668785

Table 4: Position limits (lots) in futures contracts across markets and asset classes
Nation US UK Japan S Korea Non-agri commodity
Spot mth: 3000; No limits Commercials & investment trust: 12,800; Else: 2,400 NE 3rd mth: 15%, 10%, 5% proportion; 2nd mth: 20000, 10000, 1000; 1st mth: 5000, 2000, 300; at brokerage, proprietary, clients level respectively NE
2

Agri-commodity
Spot mth: 600; Single mth: 6,500; All mths: 10,000; NE Spot mth: 500; 2nd: 2,000; 3rd: 5,000; 4th: 10,000; 5th onward 10,000 to 30,000 NE Broker: 25%; Non-broker: 20%; Customer: 10% of market open position limit; Near month 6,250; 5,000; 2,500 respectively NE All mths Client: 20,000 MT; Member: higher of 60,000 MT or 15% of market open position; Near mth Client: 6,000 MT; members: higher of 18,000 MT or 15%

Currency
No limits NE

Stock Index
Net 20,0001;

No information
NE

NE No limits3

China Brazil

India

Client: 4,00,000 barrels; Member: higher of 12,00,000 barrels or 15% of open positions

NE Higher of 10,000 or 20% of OI Clients - higher of 6% of OI or USD 10 million; trading members - higher of 15% of OI or USD 50 million, banks - higher of 15% of OI or USD 100 million

10,0004 NE Member: higher of Rs. 500 crores or 15% of total OI; Client: 5% of OI

Note: The commodity underlyings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlyings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively; NE: Not Examined 1: Net of all contracts combined (long or short); 2: Positions at ICE greater than 100 lots in all contract months to be reported on a daily basis. Exchange can prevent the development of excessive position/unwarranted speculation where appropriate; 3: Can be adopted when KRX deems necessary; 4: Long or short position for all contracts month combined Source: Exchanges websites

However, at the ICE, if members hold positions greater than 100 lots, they are required to report to the exchange on a daily basis. One is not sure what action follows and there is no transparent policy on what should be done in case of large concentration of positions in a particular contract by a particular participant. In the absence of any transparent regulations requiring examination of the data for further regulatory action, one can conveniently assume that the business interests of the exchange would prevail. In the above case, the ICE also reserves the right to prevent the development of

excessive position/unwarranted speculation where appropriate. The Shanghai Futures Exchange (SHFE) in China has imposed different position limits up to third month of futures contract. The SHFE also adopts the system of large positions reporting system. When the speculative positions of a kind of futures contracts reached or surpass 80% of the permissible speculative positions limit, members or clients are obliged to report the status of capital and position holdings to the Exchange and clients are required to make such reports through Brokerage

members. The Exchange may stipulate or adjust the reporting level according to the risk status of the market. In US, position limits are applicable only in the expiration month, while the accountability levels for the positions of more than 20,000 lots have been applied for all the months. The UK seems to be quite liberal in terms of enforcing position limits across different asset classes. For example, a Bloomberg news item released on January 5, 2010 reads One Company Holds at Least 40% of London March Copper Shorts. Unless the reported huge positions (i.e. 40%) are for bona fide hedging purpose, the high concentration definitely poses a risk to market equilibrium.

4. Periodical Review of Contract Specifications

It is essential that specifications of futures contracts are designed keeping the interests of all stakeholders in mind that they appeal to all categories of market participants and would enthuse accumulation of a healthy mix of participation interests from hedgers and arbitragers. A slight tilt towards any of these means the contract will not be able to take off. Design and introduction of futures contracts involve an expensive and time-consuming process, especially when it is a brand new contract with no global precedence to refer to. Once a contract is launched, modification of the existing/running contracts is not allowed, unless liquidity dries up altogether.

Hence, as in todays world where futures contracts are made available for several years, going for changes becomes a longdrawn process. Moreover, as time progresses and market dynamics changes, the contract needs to evolve to keep it relevant to the market. For example, in March 2009, Brent crude oil futures contract which historically trades at a discount to WTI, as former being a comparable inferior quality, traded at premium to WTI as high as USD 10 a barrel (a highly improbable behaviour). The reason for the same was a local issue. During that time storages were up to the brim in Cushing a land locked place the main delivery centre for WTI crude, began to reflect the local fundamentals compared with it being a global benchmark. The participants who may have hedged during this time period looking at historical price behaviour would have allocated wrong resources which may create systemic risk for the markets. When exchanges fail to adapt to changing market dynamics, the risk to the efficiency of its price discovery process arises. For example, waking up to nonconvergence of cotton spot and futures prices, CME, of late, is contemplating various proposals to delete a few existing deliver centres where the relevant grade cotton production has come down and to add the ones where production and physical trading have become more active in recent years. Hence to keep the contract specification relevant to the market it needs to keep evolving with changing market conditions and the

exchanges and regulators would have to consciously monitor the same analyse the potential impacts of such changes on the contract and hence the trading behaviour.

5. Robust Spot Price Polling, Dissemination and Final Settlement

The derivatives market complements the functioning of the spot market by discovering future cash prices for the participants of the spot market. In order that the derivatives market performs this role efficiently, futures prices would have to efficiently reflect the underlying fundamentals as it exists in the cash markets besides accounting for anticipated changes in the economic conditions and fundamentals at a future point in time. Ideally, the spot price of the underlying commodity and the futures price of the contract of the same underlying commodity should converge as the contract advances towards its maturity. Divergence between spot and futures prices poses a threat to efficient price discovery of futures trading and also to its hedge efficiency. Wide dissemination of polled spot prices and market discovered futures prices holds the key to countering the potential risk of divergence between spot and futures prices at it would help arbitragers to identify opportunities and to make the cash and futures markets sync up appropriately. Importantly, for arbitrageurs to act in markets, polling of spot prices needs to

be authentic i.e. without any bias or inherent defects and should remain the best reflector of the underlying spot market fundamentals. Therefore, a robust spot price polling mechanism is critical to avoiding this divergence. Another important facet of spot price polling is that there should be regular check on the relevance of the pre-decided underlying spot market for the overlying derivatives contract and any changes in the same should be reflected in contract specifications as well. Importantly for the final settlement of derivatives contract, the correct spot prices are vital if the contract is cash settled. In case cash settlement of a futures contract on expiry is based on faulty spot prices or other imperfect ingredients such as faulty storage cost and ill-representation of moisture content in the underlying commodities (largely agri-commodities) which have the potential to distort the spot prices would have to be avoided. Interestingly, in mid-June 2010, the difference between cash wheat prices in Kansas and July 2010 Kansas City Board of Trade wheat futures diverged sharply instead of converging as cash and futures prices are normally expected to. One of the many reasons cited for this nonconvergence was fading relevance of the underlying wheat quality (due to falling production). Therefore, acknowledging the importance of convergence, the exchange decided (on a pilot basis) to close the gap between futures and spot prices by adjusting it to varying storage cost.

Penalty as a tool to Discouraging Delivery Default

Delivery default penalty is a punitive tool imposed to discourage derivatives market participants from defaulting against futures contract obligations. A long hedger may have committed an export contract with his overseas buyer and would have planned to fulfil his obligation by taking the delivery against his futures position. If the seller on the day of expiry of the futures contract fails to deliver, the long hedger bears the brunt of this failure. Therefore, as a measure of precaution in physically settled contracts, exchanges increase the margins for contracts approaching their maturity. Still, if counterparty defaults, exchanges have a provision to penalise the defaulter not only to discourage potential future delivery defaults (a risk to the price risk management function of derivatives trade) but also to make good for the affected partys loss. The penalty varies from exchange to exchange, from a certain percentage of contract value to the defaulter bearing the difference in the final settlement and the procurement cost of equivalent quantity and quality. All countries analysed, as in table 5, have different methods of arriving at the settlement price on expiry of a futures contract. For oil futures contracts, the US and China follow compulsory delivery mechanism for settlement; the UK and Japan adopt cash settlement procedure. Exchanges in the UK allow EFP as a mode of physical delivery. In India, crude oil futures contracts have provided for both options i.e. physical delivery is possible when the intention of both buyers and sellers are matched. In all

exchanges which provide for physical delivery, defaults are dealt with by imposition of penalty (at least compensating for the losses). In the US, the defaulting party is slapped with a penalty of 20% of the contract value. India too imposes a penalty of 2.5% and replacement cost of 4% of the settlement price. The final settlement of crude oil futures on CME is done by a method called as volume weighted average price (VWAP). On expiry of futures contracts, the trades occurring between 14:28:00 and 14:30:00 Eastern Time is considered for declaring the final rates. In this method, the volumes are weighted against the prices to arrive at the final settlement price. As far as agri-commodities are concerned, all exchanges have the provision of compulsory delivery. On CME, soybean futures contract is settled at the price at which the Pit Committee, in consultation with the exchange staff, determines the preponderance of the volume in the closing range. In India, the settlement procedure of soybean futures is simple and straight forward. The exchange takes simple average of last 3 days spot prices of soybean to arrive at the due date rate following the expiry of the futures contract. Coming to currency futures contracts, the US and Japan enforce settlement through physical delivery, as they have no issues with full convertibility. Currency derivatives in India and Brazil, which have not yet allowed full convertibility of their currencies, are settled against cash.

Table 5: Settlement, due date rate (DDR) and delivery default penalty (DDP) in futures contracts across markets and asset classes Non-agri commodity Agri commodity Currency Stock Index Settlement Physical US Physical Physical Cash DDR DDP UK Settlement DDR DDP Settlement DDR DDP Settlement DDR DDP Settlement
VWAP between 14:28:0014:30:00 Eastern Time1 20% of contract value Cash delivery through EFP ICE Brent Index price on next day of expiry5 None Cash settled Price published by Platts7 Pit Committee price, in consultation with Exchange2 Not more than delivery price & reasonable market price NE NE NE Physical Final contract price of settlement period 1% Charges, max Yen 100 million/suspend trading NE NE NE Physical ECSP3 NE NE NE NE NE NE Physical delivery Closing execution price of last trading day Compensate loss & expenses incurred NE SOQ4 None Cash EDSP6 None Cash SQ8 None NE NE NE Cash Arithmetic avg. of underlying index in last 2 hrs of last trading day None NE NE NE Cash Closing value of spot index on last trading day

Japan

None
NE NE NE Physical delivery

S Korea

China

Brazil

DDR DDP Settlement DDR DDP Settlement DDR

NE NE NE Both Option Spot price of last trading day (Ex Mumbai) Penalty of 2.5% of DDR & replacement cost of 4% of DDR

5-20% of contract values NE NE NE Physical Simple average of last 3 days spot prices 3% of DDR + diff b/w DDR & avg. of 3 highest spot prices of next 5 days post expiry

NE NE Cash (in Brazilian Real) Rate announced by Central Bank of Brazil None Cash (in Indian Rupees) RBI reference rate of last trading day

India

DDP

None

None

Note: The commodity underlyings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlyings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively; NE: Not Examined; None - No (physical) delivery default penalty since no physical delivery settlement; 1: Front month in NYMEX WTI Crude Oil futures is settled at the VWAP (volume weighted average price) of trades occurring on expiry date b/w 14:28:00-14:30:00 ET; 2: Settled at price at which Pit Committee, in consultation with Exchange staff determines traded the preponderance of vol in the closing range; 3: ECSP Expiring contract settlement price is derived from more actively traded, next deferred contract month by applying appropriate spread differential b/w 1st & 2nd expiring contracts to VWAP of sales between 9:15:30 to 9:15:59 a.m. CT; 4: Special Opening Quotation (SOQ) S&P 500 futures index is settled taking cash market prices of underlying stocks opening prices the following day of expiry; 5: Index represents the average price of trading in the 21 day BFOE market in relevant delivery month as reported & confirmed by media (industry); 6: Exchange Delivery Settlement Price (EDSP): final settlement price of the index is arrived by the outcome of the intra-day auction at the London Stock Exchange carried out on the last trading day; 7: Yen-based monthly avg. value of Dubai & Oman calculated by Exchange based on the prices reported by a price information vendor (Platts); 8: Special Quotation or SQ calculation is based on the total opening prices of each component stock of Nikkei 225 on the business day following the last trading day; Source: Exchanges websites

On CME in the US, EUROUSD currency futures are settled based on a technique similar to that of crude oil futures (VWAP). The exchange for settlement of EUROUSD contract provides a time window of 30 seconds between 13:59:30 and 14:00:00 CT. The trades in this period are volume weighted and the final settlement price is arrived at. Stock indices futures on the exchanges analysed, as in table 5, have largely emerged as being cash settled as exercising delivery for these contracts constituting 50 to 500 shares is a tall order task for the agency responsible for clearing the trade. Settlement of indices varies from country to country. The CME adopts a method called Special Opening Quotation (SOQ) for arriving at the final settlement price of S&P 500 futures contract. SOQs are calculated based on normal index calculation procedure except that the values of the respective components are taken as the actual opening values for each of the component equities. However, not all stocks will actually record a transaction on the opening bell of the New York Stock Exchange (NYSE) or NASDAQ. Some may open a few seconds, minutes or even hours later. Thus, there will be differences between the initial index quotes on the Final Settlement Date relative to the SOQ. In the UK, the final settlement price of FTSE 100 index futures contract is arrived by a method known as Exchange Delivery Settlement Price (EDSP). The value of the FTSE 100 Index is calculated by FTSE International with

reference to the outcome of the EDSP intra-day auction at the London Stock Exchange carried out on the last trading day. EDSP for FTSE 100 futures contract is based on the Index value created by the intra-day auction in each of the constituent securities which is run specifically for that purpose by the London Stock Exchange. For the duration of the EDSP intra-day auction, continuous electronic trading is suspended in the respective securities. NYSE Liffe declares the final settlement price (the EDSP) against which all outstanding open positions in that delivery/expiry month are settled. In Japan the final settlement price is arrived at by a methodology known as Special Quotation Calculation. It is based on the total opening prices of each component stock of Nikkei 225 on the business day following the last trading day. The methodology adopted in India is the simplest of all. The closing price of the relevant underlying index in the capital market segment (or cash market) of the exchange on the last trading day of the futures contract is taken for arriving at the final settlement price. The closing price of the underlying index constitutes the closing prices of various stock components that are calculated on the basis of the last half an hour weighted average price. The methodologies adopted by the UK and India are similar. In the UK, settlement is arrived on next days cash market auction prices, while in India

settlement is arrived on the basis of the cash markets last half hours weighted average closing price. In todays fast paced and ever-changing financial market scenario, there is always a possibility of risk getting accumulated overnight. Under such conditions, India that settles its stock index futures on the same day, scores over the UK.

any failure to do would result in suspension of his membership. Similarly to ensure that the members participating are fit and proper, they have to disclose the details of any regulatory action taken against them or firms acting in concert with them. Such financial and fiduciary disclosures would strengthen market discipline and market stability, thereby improving the confidence of the stakeholders in markets. In similar lines, studies by various financial regulators suggest that recent changes in the banking and the financial sector are making safety and soundness regulation increasingly difficult. Further these studies argue that regulators should enhance disclosures about the financial condition and risk of banking institutions to enhance market discipline and reduce moral hazard. Interestingly, critics have argued that the existing disclosure norms throughout the past financial crisis (2008-2009) was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities, thus underscoring the importance of adequate disclosure in maintaining the market integrity. In the absence of the same, the Wall Street Journal editorial board in their opinion likened Fannie and Freddie to failed energy trader Enron, attacking that the two companies' for exploding debt conditions which could not be identified by the "terrible" financial disclosure standards.

6. Net worth/Disclosure To Attain and Retain Membership

Trading of derivatives is based on a high degree of leverage. Therefore, it is desirable that members participating in the derivatives market have the requisite eligibility including their net worth i.e. they are capable of meeting all the necessary parameters. In the event of ineligible members transacting in the derivatives market, the risk of default looms large and may easily take the shape of systemic risk in the market ecosystem. To counter this systemic risk, a tool that exchanges worldwide employ is laying down strict guidelines in respect of individuals net worth to determine who is eligible for exchange membership. Different types of exchange memberships warrant different net worth criteria depending on the type of risks that the participants would accumulate. Members, on their part, have to file their net worth certificates and annual statements to exchanges on regular intervals. If the net worth of a member falls below a certain level, the exchange concerned mandates him to fulfil the criterion by depositing more capital often with a condition that

Table 6: Member deposits in futures contracts across markets and asset classes Non agri commodity Agri commodity Currency Stock Index US UK Japan S Korea China Brazil
Clearing member - US$ 500,000 Clearing member - US$ 2mn Trading: JPY 1 mn1; Clearing: JPY 50 mn NE Settlement reserve: RMB 0.5 mn2 NE TCM (deposit based): Rs 30 lakhs; TCM (fee based): Rs 65 lakhs; ITCM & PCM: Rs 1 crore3 Clearing member - US$ 500,000 Clearing member US$ 500,000 Clearing member - US$ 500,000

NE
Trading: JPY 1 mn1; Clearing: JPY 50 mn NE Settlement reserve: RMB 0.5 mn2 NE TCM (deposit based): Rs 30 lakhs; TCM (fee based): Rs 65 lakhs; ITCM & PCM: Rs 1 crore3

NE NE
Min fidelity guarantee money: KRW 1 million

Transaction participants: JPY 300 mn4 NE Settlement reserve: RMB 0.5 mn NE TM: Rs. 25 lakhs; PCM Rs. 50 lakhs; TM & SCM and TM & CM: Rs. 75 lakhs3

NE
TM &TCM: Rs. 10 lakhs to Rs. 20 lakhs; TCM & PCM: Rs. 50 lacs3

India

Note: The commodity underlyings in the exchanges across the nations for non agri sector is crude oil traded at US (CME), UK (ICE), Japan (TOCOM),China (SHFE) and India (MCX); for agri sector is soyabean traded at US (CME), Japan (TGE), China (DCE) and India (MCX); the currency underlyings in the exchanges in US (CME), South Korea (KRX), Brazil (BMF) and India (MCX-SX) are EURUSD, USDKRW, USDBRL and USDINR respectively; the equity index underlyings in the exchanges in US (CME), UK (NYSE LIFFE), Japan (OSE), China (CFFEX) and India (NSE) are S&P 500, FTSE 100, NIKKEI 225, CSI 300 and S&P CNX NIFTY respectively; NE: Not Examined 1: Guarantee fund; 2: For both brokerage and proprietary membership; 3: TCM - Trading cum clearing member; ITCM - Institutional trading cum clearing member; PCM - Professional clearing member; SCM Self clearing member; CM Clearing member; 4: As Guarantee fund Source: Exchanges websites

Exchanges usually collect deposits from their members. The quantum of deposits collected signifies the level of risk perception. In the US, the deposits collected for all asset classes, as in table 6, are the same. Two major reasons for this are: different asset classes are allowed to be traded on a single exchange and the regulator for all derivatives remained the same. In the UK, the deposit collected from a clearing member is higher than that in the US. In Japan, the deposits collected by a commodity exchange from trading and clearing members are uniform as agricultural and non-agricultural commodities are traded on the same exchange, whereas the deposits collected by Osaka Securities

Exchange from its participants stands higher at JPY 300 million. The deposit structure in Japan is also different due to the existence of different regulators for various financial markets depending on their underlying asset class. As in the US, in China too, the deposit structure is uniform across all asset classes analysed due to the existence of a single regulator. In India, the deposits collected by commodities, securities and currencies exchanges are different as all three asset classes are governed by different regulators. The deposit collected by commodity exchanges is lower than those collected by securities exchanges. The deposits collected by members of currency exchanges are even lower.

7. Robustness of Clearinghouse Guaranteeing Counterparty Risk Mitigation

During the financial crisis, the clearinghouses of exchange traded derivatives segment did a fine job in handling the Lehman Brothers insolvency by clearing their positions on exchanges such as CME promptly. This prompted the regulators to think about clearing the OTC products through the formal clearing mechanism. However, the financial crisis and the past experiences clearly prove that the existence of clearing mechanism alone cant ensure flawless operation of the markets but its robustness matters a lot particularly at times of stress as they would have been exposed to during the last financial crisis. A clearinghouse also known as central counterparty is a financial institution that provides clearing and settlement services for financial and physical transactions conducted in organized platforms. A clearinghouse provides vital counterparty risk mitigation by mutualising the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that trading parties post collateral every day. These transactions may be executed on a futures exchange or securities exchange, as well as offexchange in the over-the-counter (OTC) markets. In some countries exchanges have their own clearinghouses while in

others clearinghouses are a standalone entity wherein trading parties can select or are allowed to clear through by the respective exchanges or the regulatory authorities. All members of an exchange are required to clear their trades through the clearinghouse at the end of each trading session and to deposit with the clearinghouse a sum of money (based on clearinghouse margin requirements) sufficient to cover the member's notional position on netted basis. Because all members are required to clear their trades through the clearing house and must maintain sufficient funds to cover their debit balances, the clearing house is responsible to all members for the fulfilment of the contracts. In addition, the data from the clearing house would also provide essential signals to policy making especially to ensure economic and market stability.

Along the similar lines, to bring about greater transparency (by way of reporting trades to a clearing agency) and to enable US regulators to better manage individual counterparty and broader systemic risks that are inherent in the derivatives market, the Dodd-Frank bill requires that all OTC derivatives trades should be

subjected to central clearing and trade reporting. While the bill had proposed, learning the lessons of the crisis, that all OTC derivatives including swaps shall be cleared through authorized clearing agencies it had left for how these clearing houses should be owned and governed and how the trade should be reported to the public and industry scrutiny and to the natural course of its own development.

Chief Economist Olivier Blanchard stated that the global imbalances contributed only indirectly to the crisis, while deficient regulation of the financial system, together with a failure of market discipline were main culprits (as remarked in above mentioned IMF paper as well). Thus in hindsight, the IMF paper points toward the need for appropriate regulation of markets with the right use of regulatory tools. Regulatory tools in financial markets came into being primarily to: (1) ensure that markets deliver their economic functions in an effective and efficient way, (2) control the possibility of collective irrationality in markets (including herd behaviour), and (3) prevent any financial or fiduciary defaults in markets, which has the potential to eventually lead to financial and hence economic instability. But over time, as the developed economies prospered on a liberal market environment much in the same way as their liberal outlook towards social norms, regulatory tools for controlling risks to and risks from the financial markets slipped into oblivion due to their entrenched faith in the free market theory and the forces of markets. In many cases, market practices that have evolved around the principles also have conveniently been made into history. In recent years, the tremendous growth of derivatives markets worldwide has provided commercial participants with an efficient platform for mitigating their risks. But unfortunately, this growth also has made the entire global financial

Coordinated, proactive regulation key to evolving markets efficiency

Why regulations? The IMF paper20 titled Lessons of the Global Crisis for Macroeconomic Policy 2009, approved by IMF Chief Economist Olivier Blanchard mentions that the main culprit for the build-up of systemic risk eventually leading to global crisis was deficient regulation of the financial system. Further as quoted by The Economist 21 in March 2009, IMF

20

Lessons of the Global Crisis for Macroeconomic Policy February 19, 2009, Prepared by the Research Department (in consultation with the Fiscal Affairs and the Monetary and Capital Markets Departments) Approved by Olivier Blanchard
21

What went wrong - The IMF blames inadequate regulation, rather than global imbalances, for the financial crisis March 06, 2009. http://www.economist.com/node/13251429, Retrieved on November 17, 2010

system and the economy at large vulnerable to systemic risks not so well identifiable to any particular source that would have made the markets move away from the real economy. Rapid and rolling mass of derivatives market participation and volume had paved the way for new and evolving market practices, some of which have actually been termed as market abuses. To cap it all, these retrograde developments have been happening in a less regulated environment that proved it conducive to their existence and persistence, due to the strong belief imposed upon by the invisible hands of the market forces as described by the noted economist Adam Smith. To ensure effective and efficient functioning of derivatives markets, it is necessary that an independent external force regulates derivatives markets where participants are prone to collective irrationality akin to Ants circular mill22, observed by American naturalist William Beebe in a Guyana jungle in early 20th century. Wherein, he had observed that Ants are only trained to follow the lead provided by the one whom it is following and who can overall guide them within their colony had strayed away from its path. Each ant following the one ahead of it in the circular mill was individually rational, but together they were irrational which eventually cost them their lives. Had they
22

acted independently (to move out of the mill) or guided to safety by an external agent there was a strong possibility of their survival. Similarly, it can only be brought back to appropriate functioning through an external force (apt regulation) that can potentially stop markets/participants from becoming victims of herd mentality and, thus can remain an essential instrument in maintaining efficiency of markets in delivering their economic functions. In this context, it would be worthwhile to quote Darrell Duffie23, who in his paper titled How Should We Regulate Derivatives Markets? had suggested that for reducing risk in derivatives markets, stress should be accorded to increase regulatory capital requirements, widen the role of clearing, widely disseminate OTC prices, impose position limits and encourage improvement in corporate governance especially in risk management. While some are selfimposed disciplines expected upon market participants, others are regulations which have to evolve to manage efficient functioning of the markets. Strengthening the regulatory system an endless, evolving process Lessons of global financial crisis of 2008-2009 and events that followed such as May 6, 2010 Flash Crash (as Dow Jones Index slipped by around 6 percent in 5 minutes) underscored the need for

http://expertvoices.nsdl.org/cornellinfo204/2008/03/30/circular-mills-andinformation-cascades/

23

Duffie, Darrell, 2009. How Should We Regulate Derivatives Markets? Pew Financial Reform Project. Briefing Paper 5.

effective regulatory tools in market places that can prevent snowballing of risks in financial markets. Examining the flash crash, SEC and CFTC joint investigation24 revealed that it was an algorithm of a trader to sell a total of 75,000 E-Mini contracts (valued at around $4.1 billion) based on "a target an execution rate set to 9% of the trading volume calculated over the previous minute but without regard to the price or time" that triggered the sell orders of its peer algorithms leading to accentuation of the panic that was already set in motion in the market. No wonder that it had made the regulators to think about testing of circuit breakers in equities markets that ended on December 10, 2010. Rightly so events like this and those which have led to the recent financial crisis made the US and EU regulators to initiate a process of regulatory overhaul. However, what was lacking is the consensus between the regulated and regulators as the regulated entities fear loss of business as lack of consensus and coordination among regulators across asset classes and nations would lead to a shift of more regulated markets to less regulated markets in an effort to take advantage of the rising regulatory arbitrage in an increasingly financially interconnected world. Endless process: The US is in the process of effecting most sweeping changes25 in financial regulation since the

first financial crisis of the 21st century. The American financial regulatory environment, a benchmark among the global financial services industry environment, has been expected to witness a paradigm shift affecting all Federal financial regulatory agencies and almost every aspect of the nation's financial services industry through the enactment of the DoddFrank Wall Street Reforms Bill and Consumer Protection Act. Following its enactment, the commodity, currency and derivative markets regulator in the US the CFTC had identified 30 rule-making areas including imposing position limits, streamlining OTC swap markets etc, while the equities markets regulator SEC had, on its part, started 26 rule-making processes in an effort to regulate swaps markets. These are expected to lead to new regulations that would be put in operations not later than July 2011 as stipulated by the Act. The trans-Atlantic neighbour European Union had also set in motion the process of regulatory reform through setting up of four new European regulators to strengthen supervision of the region's financialservices industry26. The agreement, reached in negotiations between the European Parliament, the EU government and the EU's executive commission, paved the way for the new supervisory system to be up and running by January 2011. Accordingly, there will a panEuropean authority in London that will supervise banks, one in Frankfurt that will oversee European insurers, and one in Paris to supervise EU securities firms.

24

September 30, 2010; Joint report titled "Findings Regarding the Market Events of May 6, 2010" by SEC and CFTC 25 Paletta, Damian; Lucchetti, Aaron (July 16, 2010). "Senate Passes Sweeping Finance Overhaul". WSJ. Retrieved on July 22, 2010.

http://online.wsj.com/article/SB10001424052748 704682604575369030061839958.html. 26 Retrieved on Jan 11, 2011 http://online.wsj.com/article/SB10001424052748 704206804575467701482721456.htm

There will also be a European Systemic Risk Board, headed by the president of the European Central Bank that will provide early warning of any wider risks building up across the EU. Significantly, the EU FOREX markets (highly unregulated as on date) are also expected to be regulated under the proposed revamped EU market regulations. The unavoidable truth is that as markets continue to evolve so is the need to improvise the regulatory system with innovative regulatory tools and mechanisms. For instance, exchanges and regulators in the US are now considering replacing circuit breakers with the limit system27. While the circuit-breaker system briefly halts trading in a specific stock if its price drops or rises by a certain percentage in certain fixed timeframe, the limit-up/limit-down model will prevent investors from trading beyond the parameters that triggers the circuit breakers, but will, at the same time, allow traders to continue buying and selling stocks within those parameters and not freeze trading in them altogether. This approach would prevent aberrant trades from occurring outside specified parameters, while still allowing trading to continue within the established limits, thus carrying an advantage over halting trading altogether, when a circuit breaker is triggered by an erroneous trade rather than a fundamental reason for a stock's slide. This merits consideration (after adequate assessment on merits and demerits) as a tool to be employed in the

markets across the globe and asset classes. Another important facet of evolving regulatory developments is that it is not limited to a particular region or particular group of countries such as the developed countries; on the contrary it has remained a realization among global policy makers/regulators. For e.g. South Korean financial authorities announced new measures aimed at preventing market shocks stemming from option expirations and to reduce derivatives-related risks28. One of the major measures, is to put a cap on institutional investors' positions (position limits) in the stock derivatives market. The action from Korean authority was largely in response to its local version of flash crash like inc ident that took place on Nov. 11, 2010 - an option expiry day, when the benchmark Korea Composite Stock Price Index Kospi, fell steeply toward the close of the market due to an opportunity for arbitrage trading that existed between the spot and futures markets. Earlier too, South Korea in June 2010 implemented a cap on banks' foreign-exchange forward positions and in December 2010 announced plans to impose a levy against banks' balance of non-deposit foreign currency debt. In short, the sustained actions of Korean regulatory authorities signifies that in order to evade major risk building up in the market, strengthening of regulation should be a process that necessarily would have to be endless.

27

New US circuit breakers trip, stumble on problems Retrieved on Jan 11, 2011 http://blogs.reuters.com/financial-regulatoryforum/2010/07/02/analysis-new-us-circuitbreakers-trip-stumble-on-problems/

28

South Korea To Tighten Derivatives Rules Retrieved on January 11, 2011 http://online.wsj.com/article/SB10001424052748 703791904576075213922333594.html

Evolving regulatory tools: An example of evolution of regulatory tools in response to the lessons learnt during the past crisis may be seen on Nordic and Baltic equity markets. NASDAQ OMX Group Inc29 introduced updated Volatility Guards on its Nordic and Baltic equity markets in Stockholm, Helsinki, Copenhagen, Tallinn and others to protect investors and listed companies during times of volatile market conditions. The Nordic Volatility Guards is utilized if an order deviates too much in percentage from the last sale price (Dynamic Volatility Guard) or the reference price, which is normally the day's opening price (Static Volatility Guard). When the Volatility Guard is triggered, trading is halted, to be followed by an auction period which lasts 60 to 180 seconds, after which the order book moves back to the process of continuous trading. Another apt example of evolving regulatory tools can be seen by the actions in Singapore Exchange (SGX). Concerned with May flash crash in US, SGX, is in process of putting adequate pre trade risk controls30, largely intended to help reduce the risk of a major trading incident amid growing issues raised by high-frequency trading. The proposed initiative will impose fresh limits on the

number of contracts that can be traded within a given period by members with direct access to the exc hanges trading engine, usually through a broking house that is a clearing member. Additionally, clearing members will also be required to agree and monitor limits with direct traders on the mix of long and short positions that can be taken, and on credit arrangements for trading on margin. This way SGX aims to minimise the danger of a crash caused by high-speed electronic traders with direct access to the market. In short, to tackle the fast-changing market environment, introducing such proactive and innovative tools by exchanges as well as regulators would remain the need of the day. On similar lines, J. Kevin31 (2009) opines that the Fed struggled to maintain order in US credit markets, which could have been averted by taking proactive steps in the mortgage market or applying broader regulatory actionsto either pre-empt or mitigate the impact of a probable market disruption. Also, there has to be a clear demarcation of regulatory priorities, especially at a time when the regulator requires walking a thin line between its statutory obligation towards maintaining orderly functioning of the markets and encouraging liquidity in the market.

29

http://www.world-exchanges.org/newsviews/news/nasdaq-omx-nordic-introducesupdated-volatility-guards-protect-investors-andlisted30 http://www.ft.com/cms/s/0/a95191b6-28fd11e0-aa18-00144feab49a.html#ixzz1CD0lXtab

31

J. Kevin Corder (July/August 2009); The Federal Reserve System and the Credit Crisis, published in Public Administration Review Volume 69, Issue 4, pages 623631, http://onlinelibrary.wiley.com/doi/10.1111/j.1540 -6210.2009.02011.x/abstract

To some extent, prevention in markets remained better than curing the situation. Prevention in financial markets can in one way be done through careful design of contracts which will prevent manipulation and remain market friendly. Allen32 (1985) observes that the main protection against manipulation in the case of cash settled contracts rests with the use of contracts that are hard to manipulate. Role of regulators is to identify those contract designs that, by some reasonable standards, do not pass the test (linked to ease of speculation in a particular contract) and to discourage their use. In this context, thanks to the recently passed Dodd-Frank Bill, the regulators in US financial markets namely the CFTC and SEC are not only striving hard at implementing numerous new rules but also vetting them strongly beforehand, so that no loopholes are left for market to exploit. Notably, inferring that position limits, fool proof contract specification or any other regulatory tools can altogether deter scrupulous trading may remain elusive but surely regulators can move a step ahead to tackle the root cause of excessive speculation. Perhaps, the vicious incentives in the industry, such as the practice of traders being rewarded for their gains but not held accountable for their losses could be one of areas to be looked into to strike the balance between

private profits Vs public losses in financial markets. Possible steps for global regulators The varying regulatory tools and the intensity to with which they are applied across financial markets in different economies on a particular asset class in some way or the other provides an opportunity to exploit the regulatory arbitrages. In such cases, the ills that the stringent regulator wants to protect the market from would in any case be spread from the less regulated market and thus leading to a counterproductive situation wherein the businesses of the regulatees were thrown away for a toss. For example, in the current scenario of position limits that are being contemplated for imposition in commodity derivative markets, a particular participant can hold high positions in the same asset class in a regulatory territory which has liberal position norms which are also not seriously monitored. In this context, before a regulator would appropriately deploy the regulatory tools explained above, it would be better first to shut the door of regulatory arbitrage and prevent ways and means by which these can arise such as constituting a global financial markets forum of various financial asset class regulators from across the globe for discussion and an authority who can issue guidelines and principles after appropriate discussion and based on common consensus. Perhaps, creation of an International Derivatives Agency, in cooperation with the G20, EU and US

32

Paul, Allen B. The Role of Cash Settlement in Futures Contract Specification. The American Enterprise Institute for Public Policy Research, Washington 1985.

authorities (as they generally act as the global benchmarks for various asset classes), to increase transparency and restore confidence in global derivatives markets could be considered. Such an authority, if established, should have the powers to monitor implementation or the practice of such principles in market practices with a power to prevent other global market traders in a market that does not adhere to their commonly agreed upon regulation in the interests of global financial stability. More than setting up principles for market regulation and monitoring its implementation and adoption, real-time coordination among regulators at the global level is more important in the world of interconnected financial markets where machines trade in equal strength with that of humans. In this context it is important to note here that during the conference in Brussels organized by trade body the Association for Financial Markets in Europe on Jan 12, 2011, Patrick Pearson33, the head of financial markets infrastructure unit within the EC, stressed the need for coordination amongst major global regulators in policing the new derivatives rule. An IOSCO consultation paper (2010)34 on dark liquidity, released recently, states

that the fast mushrooming dark liquidity over dark pools across the globe poses serious risk to fair price discovery of the underlyings, as well as impacts overall market integrity. To address these developments which provide benefits to participants defying the basic needs of markets regarding transparency and orderly conduct, the role that global-level coordination among all regulators is crucial as asset classes including that of equities that have today been made tradable due to the development of institutional arrangements that can enable the same. It further enhances the policing role of the proposed global regulatory agency beyond the organized markets into development and conduct of market practices in unorganized market places such as dark pools and that of OTC markets applying lessons of organized market places for derivatives. Along with regulatory tools it is also essential that their use is globally coordinated so that regulatory objectives are effectively met.

33

http://www.mydeltaquest.com/2011/ecofficialtoo-forex-exempt-derivatives-rules/ Retrieved on Jan 14, 2011

34

Consultation paper by IOSCO, Issues raised by dark liquidity; October 2010