OTC vs. Exchange Traded Derivatives

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OTC vs. Exchange Traded Derivatives

  1. 1. A Report:Exchange Traded CurrencyDerivatives vs. OTC MarketWhy the Exchange Traded Currency Options have pick up so well in comparison to theOTC Market?The Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial market for tradingcurrencies. Across the world the Financial Centers functions as bridge to serve the varied buyers and the sellers.Exchange Traded Derivatives are preferred over the OTC Derivatives. The reasons being: Market Liquidity,Transparency, Lower Impact Cost etc.Submitted To: Mr. Vikas Bajaj, (Business Head – Currency Derivatives, Kotak Securities Ltd.)Submitted By: Sukant Arora, (Student, Jindal Global Business School)Dated: May 27, 2011
  2. 2. ACKNOWLEDGEMENTThis Report was produced by Sukant Arora, a student Of Jindal Global Business School at KotakSecurities Ltd. I would like to thank Mr. Vikas Kr Bajaj, Business Head, Currency Derivatives, KotakSecurities Ltd. who provided me with support and encouragement during writing of this report.Without his guidance and persistent help this dissertation would not have been possible.I would like to express my sincere appreciation to Mr. Anindya Banerjee, Mr. Ratushtra Merchant, Mr.Nikhil Garg, Mr. Manish Maisheri, Mr. VinodHolani and Mr. Ankit Parekhwho supported me allthrough my summer training and guided me all the way.I would like to give full acknowledgement to the outstanding help by the staff of Kotak Securities Ltd. Ihope that this report will helpful to the readers.
  3. 3. Executive SummaryThe Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial marketfor trading currencies. Across the world the Financial Centers functions as bridge to serve the variedbuyers and the sellers. The foreign exchange market works round the clock except for the weekendsand it determines the relative value of global currencies.Foreign exchange market serves many purposes but the primary purpose of the market is to giveassistance to investment and international trade, by allowing businesses to convert one currency tothe other. For example it promotes a British business to import Chinese goods and pay Chinese Yuan,even though the income of the business is in Pound Sterling.The financial derivatives market in India have evolved through a reform process over the last twodecades, witnessed in its growth in terms of size, product profile, nature of participants and thedevelopment of market infrastructure.The OTC derivative markets in India, unlike the developed financial markets where these marketsepitomized complex, unregulated financial innovations, have evolved within a regulated space. Theprocess of evolution needs to be seen in perspective of the boundary conditions imposed by thebroader macroeconomic framework for the development of the financial sector.After interaction with large corporates & industry specialist it has come in to the point that they stillprefer to trade in the OTC market over the exchanges because of many reasons but during the recenttimes exchanges are even attracting them as the exchanges are also up to the mark on fulfilling thedemands of the large corporate.On the other hand when a large corporate is trading in the options he prefers to trade more throughthe exchanges and there are the few reasons why the currency options have pickup so well in theexchanges during recent times.
  4. 4. Table of Contents1. Foreign Exchange Market: Global Scenario……………………………………….1-22. Foreign Exchange Market: Indian Scenario………………………………………..3-43. Over The Counter Market………………………………………………………………….5-84. Evolution of Over the Counter Derivatives in India…………………………….8-95. Exchange Traded Currency Derivatives………………………………………………106. Issues with the Over the Counter Market in India………………………………11-127. Findings……………………………………………………………………………………………..13-14
  5. 5. 1.) Foreign Exchange Market: Global ScenarioThe Foreign Exchange market is a global, worldwide decentralized, over-the-counter financial marketfor trading currencies. Across the world the Financial Centers functions as bridge to serve the variedbuyers and the sellers. The foreign exchange market works round the clock except for the weekendsand it determines the relative value of global currencies.Foreign exchange market serves many purposes but the primary purpose of the market is to giveassistance to investment and international trade, by allowing businesses to convert one currency tothe other. For example it promotes a British business to import Chinese goods and pay Chinese Yuan,even though the income of the business is in Pound Sterling.Foreign Exchange Market also facilitates the Carry Trade and supports Speculation, (in which investorscan lend high-yielding currencies and borrow low-yielding currencies.)In a typical foreign exchange market an investor or speculator purchases a specific quantity of onecurrency by paying a specific quantity of another currency.The modern foreign exchange market came into light around mid-1970’s when gradually all thecountries switched to Floating exchange rates from the previous regime which was followed.Firms specializing in foreign exchange market say that the daily turnover of the foreign exchangemarket is over$ 4 Trillion presently, but, according to the Bank for International Settlements, as ofApril 2010, the average daily turnover of the foreign exchange market globally is estimated at $ 3.98Trillion, and have seen a growth of around 20% as compared to the daily turnover in 2007 which wasaround $ 3.21 trillion.Breakdown of the Daily Turnover: $ 1.765 Trillion in foreign exchange swaps $ 1.49 Trillion in spot transactions $ 475 Billion in outright forwards $ 43 Billion in currency swaps $ 207 Billion in options and other products 1
  6. 6. The foreign exchange market is a unique market and the reasons behind its uniqueness are: It has a huge volume i.e. $ 3.98 Trillion daily and therefore it leads to the high liquidity in the market. The low margins of relative profit as compared with the other markets. Its continuous operation and its geographical dispersion. The variety of factors that affect exchange rates. The use of leverage to enhance the profit margins with respect to account size. 2
  7. 7. 2.) Foreign Exchange Market: Indian ScenarioThe origins of the Indian foreign exchange market can be traced to 1978 when banks were permittedto undertake intra-day trading in foreign exchange. However, the market started growing only afterthe liberalization process picked up in 1992. The continuous improvement in market infrastructurehas had its impact in terms of the enhanced depth, liquidity and efficiency of the foreign exchangemarket. The turnover in the Indian foreign exchange market has grown significantly in both the spotand derivatives segments in the recent past. The daily average turnover saw a substantial pick upfrom about $5 billion during 1997-98 to $18 billion during 2005-06. The turnover has risen further to$45billion during 2011.The growth of the Indian Foreign exchange market owes to the tremendous growth of the Indianeconomy in the last few years. Today India holds a significant position in the Global economic scenarioand it is considered to be one of the emerging economies in the World. The steady growth of theIndian economy and diversification of the industrial sectors in India has contributed significantly tothe rapid growth of the Indian Foreign exchange market.During the year 2008 that Indian Foreign exchange market has seen a great advancement that tookthe Indian Foreign exchange trading at par with the global Foreign exchange markets. It is theintroduction of future derivative segment in Foreign exchange trading through the largest stockexchange in country – National Stock Exchange and MCX-SX. This step not only increased the IndianForeign exchange market volume too many folds also gave the individual and retail investor a chanceto trade at the Foreign exchange market, that was till this time remained a forte of the banks andlarge corporate.The importance of the exchange rate to the Indian economy has also beengreater than ever before.While the government has explicitly adopted a flexible exchange rateregime, in practice the rupee isone of most efficient “trackers” of the US dollar. The rupee’s deviationsfromCovered Interest Parity(withrespect tothe dollar) exhibit relatively long-lived swings. An inevitable side-effect of the Indianexchangerate policy has been the ballooning of foreign exchange reserves to well over a hundredbilliondollars. In an unprecedented move, the government is considering using part of these reservestofinance infrastructure investments in the country. 3
  8. 8. The foreign exchange market is divided into two segments: OTC (which includes spot, forwards and swaps) and Exchange traded currency futures & options.In April2011, the size of India’s foreign exchange market was estimated to have a turnover of $45billion per day.Of this, the OTC foreign exchange market was estimated to have a daily turnover of $34 billion whilethe exchange-traded currency futures market was estimated to have a daily turnover of $11 billion. 4
  9. 9. 3.) Over The Counter MarketFirstly it is important to understand what an OTC market is and how it functions.A security traded in some context other than on a formal exchange such as the NYSE, NSE, and BSEetc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network asopposed to on a centralized exchange. It also refers to debt securities and other financial instrumentssuch as derivatives, which are traded through a dealer network. In the same way currency is alsotraded in Over the Counter Market.Amongst the Financial Markets, the Foreign Exchange market is the most liquid Financial Market inthe world. The average daily turnover in the global foreign exchange and related markets iscontinuously growing. Foreign exchange trading increased by 20% between April 2007 and April 2010and has more than doubled since 2004. The increase in turnover is due to a number of factors: Growing importance of foreign exchange as an asset class. Emergence of retail investors as an important market segment & Increased trading activity of high-frequency traders.The growth of electronic execution methods and the diverse selection of execution venues havelowered transaction costs, increased market liquidity, and attracted greater participation from manycustomer types. In particular, electronic trading via online portals has made it easier for retail tradersto trade in the foreign exchange market.In Over the Counter Foreign exchange market (where brokers/dealers negotiate directly with oneanother), there is no central exchange or clearing house. The biggest geographic trading Centre is theUnited Kingdom, primarily London. Estimates have increased its share of global turnover in traditionaltransactions from 34.6% in April 2007 to 36.7% in April 2010.The Foreign Exchange market is divided into levels of access.Market Participants Banks: The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the banks own account. 5
  10. 10. Commercial Companies: An important part of this market comes from the financial activities ofcompanies seeking foreign exchange to pay for goods or services. Commercial companies oftentrade fairly small amounts compared to those of banks or speculators, and their trades oftenhave little short term impact on market rates. Nevertheless, trade flows are an important factorin the long-term direction of a currencys exchange rate.Central banks: National central banks play an important role in the foreign exchange markets.They try to control the money supply, inflation, and/or interest rates and often have official orunofficial target rates for their currencies. They can use their often substantial foreign exchangereserves to stabilize the market.Hedge Funds: They have gained a reputation for aggressive currency speculation since 1996.They control billions of dollars of equity and may borrow billions more, and thus mayoverwhelm intervention by central banks to support almost any currency, if the economicfundamentals are in the hedge funds favor.Investment Management Firms: Investment management firms (who typically manage largeaccounts on behalf of customers such as pension funds and endowments) use the foreignexchange market to facilitate transactions in foreign securities. For example, an investmentmanager bearing an international equity portfolio needs to purchase and sell several pairs offoreign currencies to pay for foreign securities purchases.Retail Foreign Exchange Traders: Retail traders constitute a growing segment of this marketwith the advent of retail foreign exchange platforms, both in size and importance.Money Transfer or Remittance Companies: Money transfer companies/remittance companiesperform high-volume low-value transfers. The four largest markets (India, China, Mexico andthe Philippines) receive $95 billion.Non- Bank Foreign Exchange Companies: Non-bank foreign exchange companies offer currencyexchange and international payments to private individuals and companies. These are alsoknown as foreign exchange brokers but are distinct in that they do not offer speculative tradingbut rather currency exchange with payments. They generally offer physical delivery of thecurrency. 6
  11. 11. There is centrally cleared market for the majority of FX trades, and there is very little cross-borderregulation. Due to the over the counter nature of currency markets, there are rather a number ofinterconnected marketplaces, where different currencies instruments are traded. This implies thatthere is not a single exchange rate but rather a number of different rates, depending on what bank ormarket maker is trading, and where it is.The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all importantcenters as well. Banks throughout the world participate. Currency trading happens continuouslythroughout the day; as the Asian trading session ends, the European session begins, followed by theNorth American session and then back to the Asian session, excluding weekends.Factors Responsible for Fluctuation in Exchange Rates: Economic Factors  Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a governments central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).  Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a countrys currency.  Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a countrys currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nations economy. For example, trade deficits may have a negative impact on a nations currency.  Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.  Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector. 7
  12. 12. Political Conditions: Internal, regional, and international political conditions and events can have a profound effect on currency markets. Market Psychology:  "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".  Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. 4.) Evolution of Over the Counter Derivatives in India:The financial derivatives market in India have evolved through a reform process over the last twodecades, witnessed in its growth in terms of size, product profile, nature of participants and thedevelopment of market infrastructure.The OTC derivative markets in India, unlike the developed financial markets where these marketsepitomized complex, unregulated financial innovations, have evolved within a regulated space. Theprocess of evolution needs to be seen in perspective of the boundary conditions imposed by thebroader macroeconomic framework for the development of the financial sector.The process of financial market reforms in India is less than two decades old. It was in March 1993that a system of market-determined exchange rates was adopted by India as part of a broad set ofstructural reform measures. Gradually, financing the fiscal deficit transitioned from automaticmonetization to market-based borrowings resulting in a regular supply of marketable securities. Withregard to exchange rate, it was in August 1994 that the rupee was made fully convertible on currentaccount. These reforms allowed increased integration between domestic and international marketsand created a need to manage interest rate and currency risks.It was inthe above backdropthat a menu of OTC products was introduced to enable the economicagents to manage their risks in an effective manner. 8
  13. 13. Being a bank dominated system; it was natural that these products were offered through the OTCmarket with banks acting as intermediaries. On the foreign exchange side, apart from forwards,which were in existence for long, cross currency options not involving rupee, foreign currency-rupee options and swaps were permitted for customers who have foreign currency exposures.The fundamental requirement of existence of an underlying commercial transaction forenteringinto a derivative, both on current or capital accounthas remained through the years. Thedetermination of underlying exposure is largely based on current exposure and past performancefor trade related transactions. However, as an exception, borrowers having long-term Indian rupee(INR) borrowing were permitted to use foreign currency-INR swaps to transform these into aforeign exchange liability.Clearing and Settlement Infrastructure for OTC DerivativesIn India as early as in 2002, the Clearing Corporation of India Ltd (CCIL) commenced guaranteedsettlement of inter-bank spot foreign exchange transactions and all outright and repo transactions ingovernment securities, whether negotiated or under order driven systems. CCIL has commenced non-guaranteed settlement of OTC trades in IRS/FRA in November 2008, covering over 75 per cent of themarket turnover. CCIL also offers certain post-trade processing services like resetting interest ratesand providing settlement values to the reporting members. Guaranteed settlement of these trades isexpected soon. CCIL also acts as central counterparty for spot and foreign exchange forward trades.With the enactment of the Payment and Settlement Systems Act, 2008, the ReserveBank has thelegislative authority toregulate and supervise payment and settlement systems in the country.The clearing and settlement facilities offered by CCIL are governed by the risk managementprocesses which are assessed by the Reserve Bank through its offsite monitoring and onsiteinspections. The marginswith the CCILare maintained in the form of cash and government bondsensuring the quality and liquidity of the settlement guarantee fund.Transparency and ReportingThe aggregate trade data relating to all OTC derivatives is required to be reported by banks on aregular basis. On the foreign exchange side, while banks are required to report aggregate dailysales/purchases of foreign exchange forwards and swaps, data relating to options is collected on aweekly basis. Additionally, as part of regulatory reporting, banks report to the RBI product-wisenotional principals of their outstanding derivative exposures on a monthly basis, indicating thebifurcation between trading book and banking book, and benchmark-wise details of interest rateswaps. They also report related credit risk exposure to their top ten counterparties each in thefinancial and non-financial sectors. 9
  14. 14. 5.) Exchange Traded Currency DerivativesDuring the year 2008 that Indian Foreign exchange market has seen a great advancement that tookthe Indian Foreign exchange trading at par with the global Foreign exchange markets. It is theintroduction of future derivative segment in Foreign exchange trading through the largest stockexchange in country – National Stock Exchange and as well as through MCX-SX. This step not onlyincreased the Indian Foreign exchange market volume too many folds also gave the individual andretail investor a chance to trade at the Foreign exchange market, that was till this time remained aforte of the banks and large corporate.Currently four futures currency pairs are traded through the exchanges: USD-INR GBP-INR EUR-INR JPY-INRExchanges also provide trading in Options but as of now trading in options of USD-INR is available.Exchange Traded Currency Derivatives have seen huge volumes since its inception and volumes inrecent times have gone up to $ 11 Billion daily. It has therefore invited a large number of individualsand corporates to trade.Since the inception of the trading in currency futures through exchanges, the trading volumes neversaw a major turn around and have increased manifolds as when the trading was started the dailyturnover was around $ 70 million only and now it has even gone to $ 11 billion. More individuals,corporates have shown their interests in participating through exchanges as there is no entry barrieras such in comparison with the OTC market and even though the transactions cost is very less incomparison. 10
  15. 15. 6.) Issues with the Over the Counter Market in India Contract standardization: standardization is one of the prerequisites of moving contracts towards central clearing. There is merit in going by the argument put forth in a recent Financial Services Authority (FSA) paper that there are benefits from pursuing greater standardization in itself, irrespective of whether these products are then cleared or traded on an exchange. Given the vanilla nature of products permitted in the Indian context, standardization for existing products may not be difficult. Bilateral collateralization: though bilateral collateralization is considered an efficient, though sub-optimal, solution to central clearing, it involves significant trade-offs.  Move towards increased collateralization could increase cost for hedging by the real sector and place huge premium on availability of good quality collateral. In case of client trades, it may need to be recognized that a bank-client relationship is a much broader one and could include a credit relationship as well. Provision of a facility-wise collateralization may work against the smaller clients which face difficulties in managing liquidity on a daily basis.  Operationally, collateralization is effective only ifthe exposure is calculated frequently and there is a mechanism to exchange collateral dynamically. Who would ensure this? It will invariably again be the bank’s own model which will be used to arrive at both the exposures in favor or against the bank.  From a systemic perspective, there is also the issue ofprocyclicalitythat gets hardwiredin the system through mark-to-market based collateralizationand this would be equally applicable in the central clearing model. Push towards central clearing: while CCP model is accepted as an ideal solution form a counterparty risk perspective, it is being increasingly recognizedthat a universal acceptance of CCP model would result in the concentration of risks at one point, which would potentially become the single point of failure for market stability. Certain issues become extremely critical in this regard:  Clearability of contracts would be a key issue. The essence of a CCP arrangement is netting and margining, which are contingent on homogeneity of the underlying asset, availability of reliable prices and soundrisk models to capture potential future exposures. The ability of models to capture tail risks is, however, put to question post crisis. 11
  16. 16.  It would become imperative for the CCPs to be treated as ‘too-big-to-fail’ systemic entities and be brought under the oversight of the systemic regulator within a globally harmonized set of standards. In this regard one important and as yet unresolved question is whether CCPs should have access to central bank credit facilities and, if so, when. Given the incentives structures and the lack of competition in such market infrastructure entities, it may be worthwhile to consider CCPs as “public utility” and organize them as at-cost entities. Higher capital requirements for non-cleared trades: the Basel requirements already prescribe a capital charge for credit risk exposure of banks arising out of OTC derivative transactions. In as much as these exposures are reckoned on a gross basis, there is already a disincentive for bilaterally cleared OTC transactions as against centrally cleared transactions. To further address the systemic risks inherent in significant inter-bank OTC transactions, all such inter-bank exposures may be subject to a higher capital charge. Role for bespoke products:this issue is more relevant for jurisdictions involving product regulation, as in India. The trade-off is between the requirements of the real sector and the risk assessment of the product. To give an example, certain zero-cost foreign exchange option/swap structures were permittedin the past to enable better design of hedging solutions for clients. These cost reduction structures, introduced in 1996 inherently involved a trade-off between reduction in the cost of hedging and retention of part of the downside risk. The concerns relating to proper valuation, mis-selling of such products and other irregularities that emerged in the recent past forced a re-evaluation of the propriety of allowing such products in India.However, interestingly, many corporates and industry associations represented that prohibitingcost reduction structures will seriously impede the dynamic foreign exchange risk managementoperations of corporates and their competitiveness in the global markets. It has been suggestedthat structures may be allowed with additional safeguards to address the leverage and mis-sellingissues. 12
  17. 17. 7.) FindingsAfter interaction with large corporates & industry specialist it has come in to the point that they stillprefer to trade in the OTC market over the exchanges because of many reasons but during the recenttimes exchanges are even attracting them as the exchanges are also up to the mark on fulfilling thedemands of the large corporate. While trading in the futures or forwards contract what a corporateprefers is that: There should be high liquidity even in the far month contracts so as of now large corporates prefer to trade in OTC market rather than trading through the exchanges. Large corporates also wants to even sometime have the customization in their contracts and this need is catered by only the OTC market. In OTC market large corporates and even medium size industries doesn’t have to deposit large amount of initial margin as compared to when trading with the exchanges, so the preference to trade goes to the OTC market.On the other hand when a large corporate is trading in the options he prefers to trade more throughthe exchanges and here are the few reasons why the currency options have pickup so well in theexchanges during recent times: Exchanges have narrowed the spreads: If anybody is buying or selling the options, he gets a better bid/ask price in the exchanges as the product pricing is refined and therefore exchanges provide better spread than the OTC market. Costing: Exchanges provides a very good costing structure as compared to the OTC market. The charges are almost negligible other than the brokerage. Costing in terms of brokerage is also less.But In India we see that exchange traded currency has pickup so well in recent times as compared tothe global scenario, as globally OTC market dominance is there in foreign exchange and has more than95% foreign exchange dealing is done through the OTC market, but in India OTC market only hasaround share of 84% in currency dealing and as per Indian scenario there are many reasons for behindthe successful working of exchanges as that are as follows: 13
  18. 18. No Entry Barrier: Unlike the OTC market, an exchange doesn’t have any entry barrier to trade.Everybody is eligible to trade, no matter if he is a large corporate or small investor.Costing: A transaction cost in trading through exchange is comparatively very less as in the OTCmarket, so people give to trade through exchanges.Exchanges provide good volatility to trade, which is considered a most important indicatorwhile doing a trade as a hedger or even as a speculator.Transparency: This is also one of the major reasons why people prefer to trade in the exchangetraded currency market as there is complete transparency in the trades and a contract note isgenerated after every trade.Accessibility to trade even to the Non Institutional Clients: As there is no such entry barrier inthe exchange, so even the small trader or speculator can come and trade in the currencymarket, thus this generates large volumes in the exchanges and even is helpful in providingmore liquidity in the market. Filtration of the Banking System: Somewhat exchanges have been successful in filtering thebanking system by shifting the speculators from OTC market to the exchange traded market.Easiness of Documentation: There is a very little hassle in doing the documentation whiletrading through the exchanges.Alternative for speculators: As in recent times when equity market was not supportingspeculators, currency trading provided an alternative product to speculate. 14

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