NSE vice president and head of the derivatives segment, Ashish Kumar Chauhan -- an alumnus of IIT Mumbai and IIM Calcutta -- in an interview with Prashant Mahesh of FE-Thinktank delved on the various issues involved in derivatives’ trading.

The NSE first mooted the idea of trading in stock index futures in 1996. What changes has the market witnessed since then?
Things have definitely changed a lot both qualitatively as well as quantitatively since 1996.

To start with, NSE's reach has spread from 100-odd cities to more than 300 cities today. Similarly, volumes on the NSE have increased by 200-500 per cent even as the Indian market capitalisation has crossed Rs 10,00,000 crore.

Today we also have a well-established depository, which has eliminated the hassles of dealing in physical paper and simultaneously solving the problems of bad delivery.

Computerised trading has brought in transparency while the cost of transaction has fallen drastically.

The level of automation in banks is also high. Computerised trading allows for more people being able to trade on the bourses. Even the domestic mutual fund industry is much stronger than what it was a few years ago.

So is India ready for derivatives trading today?
It would be better to ask whether India is ready for an equity derivatives market since derivatives in other areas like commodity forwards, exchanges rate forwards, interest rate swaps, etc., are already prevalent in India.

There are four key aspects to this question:
Derivative markets need to work off a large foundation of asset value that is traded in an underlying market. India's debt market has a total market capitalisation of close to Rs.125 trillion and the equity market's capitalisation is close to Rs 10 trillion.

Internationally, derivatives' trading has succeeded in countries with much smaller markets. Israel, Johannesburg and Brazil are all examples of these. This only means that India too could introduce derivatives in its markets.

Secondly, as far as liquidity is goes NSE proposes to launch stock index futures based on the Nifty. The market impact cost seen at the Nifty is comparable to some of the most liquid market indices in the world (eg., the US S&P 500).

Thirdly, for derivatives to be used on a largescale it is important to have a clearing corporation which guarantees the trades. From July 1996 onwards with the NSCC guaranteeing trades on the NSE, this pre-requisite for a derivatives market now exists in India.

Lastly, India's finance industry has a sound human capital foundation on which is required for derivatives to succeed.

Which is the first product that you propose to introduce? What will you follow it up with?
To start with, we plan to introduce trading in stock index futures. World wide it has been found that the most successful contracts are the index futures, followed by index options followed by security options.

Stock index futures is a simple product and easy to understand. Depending on its success we propose to go ahead with index futures, index options and stock options.

Margins would be drawn out as per the JR Verma committee recommendations.

The cash markets seem to be pretty volatile at times. Many times prices get locked at the upper or lower end of the circuit? Would derivatives help in changing this scenario?
Derivatives would certainly help in altering this scenario. Today, whenever there is panic in the market the investor has no other option but to sell in the cash market, which adds to the panic.

However, once the investor gets a product like index futures which will allow him to hedge, he may not necessarily repeat his previous act of selling in a panic. He may, for instance, sell the index futures and hedge the risk of the portfolio value falling.

So how soon is trading likely to start and how many members have agreed to participate?
Once there is formal communication from Sebi, we will invite membership in this segment. We will get the funds from the members and get ready with our systems.

At the same time, we will also start a mock trading session to help members get conversant with the system.

When we had suggested the derivatives trading way back in 1996, as many as 220 members had agreed to participate. Then, the deposit with the exchange for obtaining membership was very high. Today, it has been reduced and a trading member has to only pay Rs 8 lakh as deposit.

If he also wants to be a clearing member, an additional Rs 25 lakh deposit in cash and Rs 25 lakh as collateral will have to be deposited with the National Securities Clearing Corporation (NSCC).The clearing member would also have to be high net worth individual of Rs 3 crore. A trading member may select to settle his trades through another clearing member.

Since this amount is much lower than what was proposed in 1996 and with the market passing through a bull phase, in all probability the number of members willing to participate would be substantially higher.

Electronic transfer of funds is still not possible in India. Would this prove to be a hindrance to trading in derivatives?
No. This statement itself is incorrect. Even today electronic transfer of funds exist between the broker and the exchange. NSE collects margins on a daily basis from its members via the electronic funds transfer facility. Private banks and new technologies have made transfer of funds much smoother and more efficient.

To avoid the daily debit/credit with clients, the broker might like to have an arrangement with his investor. Here, the broker would charge the investor a maintenance margin besides the initial margin. If and when the maintenance margin falls below a certain level, the broker would ask the investor to pay that amount.

How will the exchange monitor the risk in the derivative segment?
The derivatives segment will have an elaborate risk management system in place as suggested by the LC Gupta committee report, JR Varma committee report and, the existing risk management system at the NSE. We will check out each and every order that is being routed through the system for validity. The portfolio changes that take place because of each trade would be checked against each member's exposure.

A warning would be given to the member when his position reaches 80 per cent of his limit, followed by a similar warning when it reaches 90 per cent. Finally, his terminal would be de-activated at 100 per cent and then he would have to pay fresh margin money. Value according to the risk methods suggested by the JR Varma committee would also be used for calculation of the portfolio risk.

Who will be the initial participants? Would the exchange restrict trading to institutions and other big players?
Minimum size of a contract is expected to be worth Rs 2 lakh. The exchange will follow the Sebi regulations regarding the minimum size of the contract, type of participants, limit on open positions per participant, etc.

In addition, the exchange will on a continuous position mark to market the brokers' position in addition to calculating the value-at-risk.

Sebi has stipulated that a broker should segregate his personal account from the clients' account to ensure that the broker does not use the clients' money for proprietary trading.

What is the kind of volumes you expect to be generated on this segment in the first year?
Since trading has not begun it is very difficult to estimate the kind of volume that the segment could throw up. When the NSE was started five years ago, volume on all the exchanges was in the region of Rs 200 crore. Today, NSE's turnover has crossed Rs 7,000 crore and the number of trades has risen to 6.6 lakh.

As an exchange we are well placed in our systems to handle large volumes. Internationally, there are more volumes in the derivatives market than volumes in the underlying market.

Over the last three years, the NSE has reportedly trained a lot of individuals in derivatives? Could you elaborate on the training methodology and other efforts made by NSE?
The NSE has launched a certification in financial markets called NSE's Certification in Financial Markets (NCFM) to make its members and sales staff well conversant with the terminology. This is an on-line certification test, which is carried out from seven cities each day.

The test is application-oriented on the practical usage of derivatives and, if one scores more than 60 per cent marks he is awarded a certificate and he is then eligible to act as an intermediary in the derivatives market.

Over 1,500 individuals have already been certified under this programme.

But, it is just not enough to educate brokers.

Therefore, the NSE is trying to educate the investors too across 50 cities on simple things like what is an index, how does one compare the index, how to trade the index, how to use the index futures, etc.

Through these programmes we have covered around 10,000 individuals in the last two months.

Besides this, we have conducted numerous seminars via various fora like the ICAI, ICWAI and Ignou among others.