Come February and derivatives' trading will culminate at the Indian bourses. The LC Gupta and JR Varma committees, set up by the Securities and Exchange Board of India (Sebi), had explored the scope and the risk management aspects of the instrument. Only after all such study that the instrument is being introduced at the leading stock exchanges of the country, and definitely it is a step towards inviting the foreign investor with much verve and vigour.

The concerned stock exchanges automatically bear the onus of introducing the instrument at their respective ends with the ultimate responsibility taken on by the Sebi. The exchange board will ensure success of the risk containment measures, keep tabs on price manipulations as also monitor to see that the exchanges foster the right environment for trading of the instrument.

Certain vital requirements for the smooth functioning of this instrument were highlighted by the above mentioned committees. Risk management being a major area of concern. The Varma panel had recommended that at the end of six months of futures trading, Sebi should review the risk containment measure with specific reference to removal of transitional provisions, review of margins for calendar spreads, position limits and, cross margining between the cash and futures markets.

The Varma committee was more equivocal in its approach on cross margining than the Gupta panel. For the present, Sebi and the stock exchanges have decided against introducing cross margining and reserve it for a later date. Cross margining is essentially that the risk in one product would be offset by risk in another product so that the overall risk is lower than the individual risk.

The Gupta committee has clearly stated that operations of the underlying cash markets, on which the derivatives’ market is based, needs improvements -- "The equity derivatives market and the equity cash market are parts of the equity market mechanism as a whole". The committee has also opined that the entry requirements for brokers/dealers in the derivatives' market has to be more stringent than in the cash market.

The Varma committee differed on this issue - "It does not make sense to have laxer risk containment measures in the cash market than in the derivatives market". "The margins in the cash market should be based on a 99 per cent value at risk", stated the committee. The margins applicable ought to be twice that in the index futures market (as an interim measure) -- "since individual securities are roughly twice as volatile as the index". It also recommended lower exposure limits as compared to the derivatives' market.

Incidentally, the Gupta committee has recommended doing away with the regulatory prohibition on the use of derivatives by mutual funds but -- "only for hedging and portfolio balancing and not for speculation" -- with effective control in this regard was to be exercised by the trustees of mutual funds. It did not favour detailed Sebi regulations here thereby allowing for flexibility and development of ideas.

Since derivatives are still very new in India, Sebi has yet to take a decision on this. That is, whether the mutual funds should be allowed to use equity derivatives as a means of hedging; though informed sources maintain that it is working on it.

The committees differed on the initial margins that the trading members are required to pay as well. While the Gupta report suggested 6 per cent, the Varma committee plumped for five per cent. Both are based on variations in the index since index-based futures would be the first product. The Sebi, on its part, has accepted the Gupta committee recommendations. Officials say this relaxation may be permitted later depending on fluctuations and volatility in the index.

The Varma committee disfavours limitations being imposed at this stage on the total market wide open interest. That is, as a percentage of the underlying market capitalisation. However, there are broker limits and customer limits in existence.