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SWISSDERIVATIVESISSUE 29 – NOVEMBER 2005

Review

Official publication of the Swiss Futures and Options Association, SFOA.SW I S S

F U T U R E S

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O P T I O N S

ASSOCIATION

Focus

Derivatives in India

Review 26th Bürgenstock Meeting

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Table of Contents

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3EditorialPaul Meier, Chairman, SFOA 5

FocusA brief business look at India 6

Pramod Shedde, President & CEO, BTS Investment Advisors, MumbaiAlois Flatz, Managing Partner, BTS Investment Advisors, Zug

Derivatives markets in India 8Sundararaman, Vice-President, NSE

NCDEX: The future of commodity derivatives 10P. H. Ravikumar, Managing Director & CEO, NCDEX

MCX: emerging name of the emerging economy 16Jignesh Shah, Managing Director & CEO, MCX

What are you doing in India? 18Bruce B. Lawrence, CDLS Consulting

India – the crouching tiger 20Michael Gorham, Susan Thomas and Ajay Shah

EventReview of the 26th Bürgenstock Meeting 26

Michael Brewer, Word+Image (Text)Max Hermann (Photos)

Emerging MarketsProceedings of the Emerging Markets Forum at Bürgenstock 36

Dr Jonathan Butler, Project Manager, Deutsche Börse Systems AG Simona Simon, Derivatives Market Business Development – Sales, Eurex Frankfurt AG

InterviewThe necessary evil – Interview with Dr Sharon Brown-Hruska, Commissioner, Commodity Futures Trading Commission (CFTC) 38

Wolfgang Weber-Thedy, Weber-Thedy Corporate & Financial Communications

Legal & ComplianceEU/US dialogue in financial services: time to make a start! 40

Anthony Belchambers, CEO, Futures & Options Association (FOA)EU financial markets regulation – winners and losers 42

Richard Britton, Consultant on International Regulatory Matters, International Capital Market Association (ICMA)

New ProductsAs easy as ABC – Euronext.liffe’s new wholesale services 46

Fraser Cowie, Executive Director of Marketing, Euronext.liffe

Alternative InvestmentsExtract high risk premium in Asia through dynamic hedge fund strategies 49

Hans-Jörg Baumann, CEO & Chairman, Swiss Capital Alternative Investments AGXiao Zhang, Associate Director, Swiss Capital Alternative Investments AG

Why insurance linked securities are attractive investments after the hurricane season 54Silvia Graemiger Theler, Vice-President, Bank Leu

ProfileWhat is happening in South America? 58

Gustavo Picolla, President & CEO, Mercado a Término de Buenos Aires (MATba)

SFOA – Swiss Futures and OptionsAssociationMs. Carol Gregoir, Secretary General18b, rue du Gothard, P.O. Box 325CH-1225 Chêne-Bourg, SwitzerlandPhone +41 22 860 21 03Fax +41 22 860 21 15

AFM – Association of Futures MarketsMs. Krisztina Kasza, Head of SecretariatRobert Karoly krt. 61–65Budapest 1134, HungaryPhone +36 30 34 35 370 Fax +36 1 477 [email protected], www.afm-org.hu

ACI SUISSE – The Financial MarketsAssociationMr. Otto Amberg, Secretary Generalc/o Schroders & Co. Bank AGP.O. BoxCH-8021 Zürich, [email protected]

IFRI Foundation – International FinancialRisk InstituteMr. Peter Guidolin,Executive Manager2, cours de RiveCH-1204 Geneva, SwitzerlandPhone +41 22 312 56 78Fax +41 22 312 56 [email protected]

SAMT – Swiss Association of MarketTechniciansc/o ISFB, attn: Ms. Brigitte Wicht-Ricci7, route de DrizeCH-1227 Carouge, SwitzerlandFax +41 22 827 23 [email protected], www.ifta.org/SAMT

S W I S SF U T U R E SA N DO P T I O N SASSOCIATION

SWISS DERIVATIVES REVIEW 29 – NOVEMBER 2005

Dear Members and Friends of SFOA

Edi

torial

5Dear Members and Friends of SFOA!

We are looking back on a most exciting and interesting Bürgenstock confer-ence 2005. The thrill of the Royal Airforce Red Arrows flying their stunningaerobatics show will no doubt be remembered fondly by all participants. The visit of the pilots during the opening cocktails was a fitting end – it was great to meet with the special group of guys flying those planes. The donated a flight suit, properly autographed by the pilots, which was thenauctioned off at the Friday night event and brought EUR 25000 for theMacMillan Cancer Fund – a charity supported by the Red Arrows in mem-ory of their friend and colleague Matt “Jarvo” Jarvis who died of cancer thisspring. A special CD of pictures from the event was made and can be ordered(a special note can be found in the Bürgenstock Review section on page 34)with the proceeds going to the MacMillan Cancer Fund.

It was a spectacular opening to a very good conference. The beautiful weath-er and the great surroundings of the Bürgenstock resort made for an appro-priate setting for the event. A lot of interesting panels took place and manypassionate discussions ensued, which obviously is the idea. The social eventswere very entertaining and helped the networking, making new friends andgetting old ones together again. I hope those that attended enjoyed it asmuch as I did and I am looking forward to see you at the latest next year.The next Bürgenstock conference is slated for Sept 6–10, 2006 – mark yourcalendars!!

Everybody thinks and talks of China when speaking of the big new oppor-tunities. Obviously there are good reasons for that – but there are otherareas, that should not be overlooked. India is one of them and therefore wedevote the Focus of this issue to this rapidly growing economy and especial-ly derivatives markets. It is a country that offers a lot of opportunities, is onthe forefront of technology and is well worth taking a closer look at! In addi-tion you’ll find interesting information on new developments in the compli-ance and new product fields.

Already it’s that time again – this is the last issue in the old year. My thanksgo to our loyal readers as well as to our advertisers, without whom the pub-lishing of this magazine would not be possible!

I hope this year was good to you and your family, friends and business andwish you all the best for the new year – may it bring you lots of joy, happi-ness, success and above all good health!

Sincerely,

Paul Meier


Economic OutlookThe investment climate in India in2004–05 continues to be buoyant withthe country receiving a record USD 3.75billion in foreign direct investment dur-ing the year. In the FDI confidence index04 of AT Kearney, India was ranked thethird most attractive destination in theworld. The analysis by CRISIL a leadingrating agency in India has indicated thatthe GDP has grown by 8.10% and thegrowth rate is expected to be in therange of 6.75–7.00 per cent during2005–06. The industrial and servicessectors have shown a robust perform-ance, growing at 7.8% and 8.9% respec-tively, in 2004–05. A noteworthy pointis that the poor performance of agricul-ture has had no perceptible impact onindustrial activity, indicating a gradualinsulation of industry from monsoons.Both exports and imports maintainedtheir buoyancy during April–January2004–05, with exports growing at 25 per cent and imports at 35 per cent.The foreign exchange reserves, aboveUSD 140 billion also reflect a strongposition.

Business Outlook The country’s industrial growth acceler-ated in the last fiscal year as strong con-sumer demand and rising exports liftedmanufacturing output. Except mining,all other sectors expanded faster result-ing in an acceleration of overall growth.Considerable FDI inflow was targetedtowards mergers/acquisitions, productdevelopment, capacity expansions,strategic investments and marketing tie-ups. The country saw a growing out-sourcing trend which provided fillip toindustries such as IT and ITES, automo-tive ancillaries, value-add services, man-ufacturing, development and testing etc.On the other hand significant capacityexpansions in core sectors drove thedomestic markets.

Financial MarketsThe financial sector in India has gonethrough a sea change due to the reformsin terms of opening up of the sectorallowing foreign banks to set up base inthe country although further reforms inlicensing and foreign participation wouldbe required. The sector is further consol-idated by mergers and acquisitions,thereby improving overall efficiency. Asignificant increase in product offeringsas well as range of services by the bankshas been evident in this sector. Similarlythe insurance sector both life and non-life is being liberalized with participationby leading names from abroad.

Stock ExchangesThe stock markets have shown sharpincrease over the last couple of years onthe back of significant inflows from for-eign investors and strong corporateresults. From a low of 2,924 in April2003, the market index of Bombay StockExchange rose to more than 8,000recently. The foreign investors pumpedin USD 6.59 billion in 2003, USD 8.5billion in 2004 and USD 7.68 billion inthe first 8 months of 2005. The rally hasbeen across the board and the stockmarket has been scaling new peaks in the recent past. Also there has been sig-nificant improvement in the regulatoryenvironment in the last few years which

has enabled bringing in further disciplinein the market. Move is afoot to corpora-tise Bombay Stock Exchange which islikely to boost public confidence in themarkets and usher in good governance.

Private Equity ScenarioIndia is currently one of the fastest grow-ing private equity markets in the worldand is estimated to have grown at anaverage of 70% annually in the last 7 years. The industry continues to bedominated by foreign players and ahandful of significant domestic institu-tional players. The noteworthy trendsare that the investments are acrossdiverse sectors which includes life sci-ences, manufacturing, infrastructure andfinancial services. Recent attractionsinclude retail, real estate and airlines.There is clearly preference to growthcapital and expansion financing toensure risk optimization and reasonablyearly exits. Investments in listed compa-nies are preferred by larger fundsthrough private placements to ensureliquidity and stock market movements.The key drivers of the PE industry are aproactive regulatory environment, con-tinuing capital market reforms andincreasing corporate governance stan-dards bringing in transparency andglobal management styles.

A brief business look at India

Pramod Shedde, President and CEO,BTS Investment Advisors, Mumbai

Alois Flatz, Managing Partner, BTSInvestment Advisors, Zug

www.btsadvisors.com

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Over the past few years, the Indian capi-tal market has been attracting consider-able international attention. The mainreasons are changes in the marketmicrostructure, general market reformsand the overall robustness of the econo-my. At market prices, India’s annualGDP is at nearly USD 800 billion, andthe ten-year trend GDP growth rate is at6.3%. At about 28%, the savings rate inIndia is very high.

The major reforms in the last decadestarted with the launch of the NationalStock Exchange (NSE), the largest stockexchange in India, as a fully demutual-ized electronic exchange with 100%dematerialized settlement, shortened set-tlement cycle, and settlement guaranteethrough the National Securities ClearingCorporation Limited (NSCCL), a whol-ly-owned subsidiary of NSE. They fur-ther include the introduction of deriva-tives trading and the simplification ofrules for the participation offoreign clients in Indian mar-kets.

While some Indian equi-ties markets and stockexchanges are more than acentury old, exchange tradedderivatives are fairly new.Derivatives trading commenced in June2000. Presently, four products namelyindex futures, index options, stockfutures and stock options are activelytraded. NSE currently has a market shareof around 99%. In these five years ofderivatives trading, the market has seensignificant growth with derivatives vol-umes climbing faster than the underlyingequities markets at NSE.

The index futures and options arebased on the popular market benchmarkof India, S&P CNX Nifty. S&P CNXNifty is owned and maintained by IndiaIndex Services and Products Limited(IISL), a joint venture of NSE andCRISIL, which has a consulting andlicensing agreement with Standard &

Poor’s (S&P). This index comprises 50stocks and represents more than 20 sec-tors of the economy and 50% of the totalmarket capitalization. The stock futuresand options are based on 119 highly cap-italized and liquid stocks of the under-lying market. Presently all contracts arecash settled. The market is predominant-ly retail and client transactions accountfor more than 60% of the volume.

There are more than 675 members inthe derivatives segment of NSE operatingfrom around 310 cities and towns inIndia. Futures contracts account forabout 85% of the total derivatives vol-ume, the remaining being attributable tooptions. Stock futures with a daily aver-age of more than 325,000 contractsmake the NSE probably the largest stockfutures exchange in the world in terms ofnumber of contracts.

The products are very liquid. Theaverage open interest of all the four

product groups is more than 100% ofthe average number of contracts tradeddaily. The bid-ask spreads are attractive.In respect of most of the underlying secu-rities, the total derivatives volumes havealready exceeded the volume traded inthe underlying market. With the marketmaturing, this ratio is expected to furtherclimb sharply. The average size of a tradeis close to a single contract indicating thepredominance of retail traders. Theregional distribution of volumes is even,mirroring the underlying market.

A sharp bend in the curveIn the first year of operations, i.e. fromJune 2000 to May 2001, the growth inderivatives trading was understandably

moderate. The average monthly tradedvolume was around USD 50 million.With the introduction of index options inJune 2001, the traded volume rosesharply to USD 175 million. During July2001, options on individual securitieswere introduced. In addition, compul-sory rolling settlement in respect of asignificant number of securities waslaunched and the use of deferral prod-ucts for creating new positions wasbanned apart from transferring it torolling settlement cycle. As a result, themonthly volumes rose to USD 451 mil-lion in July 2001. In November 2001 theintroduction of futures on individualsecurities boosted monthly volume toUSD 1,946 million. The launch of singlestock futures propelled the NSE to theleading position among the internationalexchanges in this product. In January2002, NSE’s derivative volume increasedby over factor two in two months to set-

tle at about USD 5 billion.Further reduction of settle-ment cycles, ultimately toT+2 in the cash market gavea boost to derivatives and the volumes increased to USD58 billion in March 2004 anincrease of more than 5 times

year-on-year. The current average dailytraded value ranges from USD 3 to 4 bil-lions.

Clearing and settlement All trades executed at NSE’s derivativessegment are cleared and settled by theNational Securities Clearing CorporationLtd. (NSCCL). NSCCL is a wholly-ownedsubsidiary of NSE. All the derivatives con-tracts are settled on cash basis. All deriva-tives products are settled on T+1 basis,except for stock options, which are settledon T+2. NSCCL provides settlementguarantee at client level. The clearing cor-poration has established on-line connec-tivity with the clearing banks, enablingelectronic debits and credits.

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Derivatives markets in IndiaThe National Stock Exchange (NSE) was established in the mid 1990s as a demutualized electronic exchange

in India. The NSE revolutionized equities trading and has become India’s largest stock exchange. Continuing

with its pioneering zeal, the exchange has introduced derivatives products five years back and in this short

span of time has become No 1 in stock futures and the tenth largest futures exchange in the world.

“NSE is the worldwideleader in stock futures.”


Risk management NSCCL has put in place a comprehensiverisk management system, which is con-stantly upgraded to pre-empt marketfailures. The risk management is done onan on-line, real-time, client-level andportfolio basis. The system proved itselfvery robust by successfully handling themajor market fall of around 25% overtwo consecutive days in May 2004 with-out any defaults.

Foreign investorsForeign investors are permit-ted to trade in India in bothderivatives and the underly-ing market segment by regis-tering themselves with theregulator, the Securities andExchange Board of India(SEBI) subject to the stipulat-ed conditions. Such entitiesregistered with SEBI are known asForeign Institutional Investors (FIIs).Over the past year more than 175 new FIIs have registered with SEBItaking the total number of FIIs to over750. The simplified procedure to registeras an FII has helped many new FIIs tocome to India. FIIs have the facility totrade through multiple trading membersbut can clear and settle through a singleclearing member. In the underlying mar-ket, these institutions have a facility toclear and settle their trades throughCustodians.

The activity of FIIs has recently seen a significant increase both in the under-lying and in the derivatives markets. In July 2005 FIIs contributed about USD 9 billion to total NSE turnover.Compared to USD 2.5 billion in August2004, this is an increase of more than250%. In the previous year, FIIs contri-bution to NSE’s derivatives turnover hasincreased from 3% to 8%. FIIs hold over30% of the market’s total open positions.

As other investors, FIIs are subject toposition limits. To boost the FII partici-

pation in Indian derivatives markets,SEBI recently extended the position lim-its for FIIs. The currently applicable posi-tion limits for FIIs are as follows: FIIposition limits in index futures or indexoptions are higher than USD 55 millionor 15% of the total open interest of themarket in index futures or index optionsrespectively for each underlying index. Inaddition, FIIs can take exposure in equi-ty index derivatives subject to the follow-ing limits:

• Short positions in index derivatives(short futures, short calls and longputs) not exceeding (in notional value)the FII’s holding of stocks.

• Long positions in index derivatives(long futures, long calls and shortputs) not exceeding (in notional value)the FII’s holding of cash, governmentsecurities and similar instruments.

The FII position limits in a derivativecontract on a particular underlying secu-rity, i.e. stock option contracts and singlestock futures contracts are as follows:• For securities in which the market

wide position limit is less than or equal

to USD 55 million, the FII positionlimit in such stock shall be 20% of themarket wide limit.

• For securities in which the marketwide position limit is greater than USD 55 million, the FII position limitin such stock shall be USD 11 million.

As there are investments limits for in-stitutional investors with respect to indi-vidual stocks, the index’ revised andexpanded positions limits is therefore agood tool for hedging and/or taking

exposure on the Indian mar-ket as a whole.

ConclusionIn 5 years from its com-mencement, the derivativessegment of National StockExchange of India (NSE), themain financial derivativesexchange of India, sports sev-

eral achievements: Worldwide, the NSEranks among the top 10 futures ex-changes, 16th among the futures andoptions exchanges, and 4th in the indexfutures segment in contract terms amongthe derivatives exchanges in the world.NSE is the market leader in stock futuresin terms of contracts and turnover value.With the projected growth of the Indianeconomy, the markets are expected togrow further in terms of volumes, li-quidity and coverage. The index deriva-tives segment is shaping as one of the core areas of development, withNifty future being one of the most liquidproducts.

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Sundararaman is Vice-President with the National StockExchange (NSE). He is in charge of clearing, settlementand risk management functions at the National SecuritiesClearing Corporation of India, a wholly-owned sub-sidiary of NSE.

Contact: [email protected]

“The average size of a tradeis close to a single contractindicating the prevalence of retail traders.”

“Foreign InstitutionalInvestors hold over 30% of the total open positions.”


Commodity trading in IndiaIn India, futures’ trading in commoditieshas a long history. The Bombay CottonTrade Association Ltd. was set up asearly as 1875 while futures markets inBullion trading began in 1920. As ofdate, there are 24 commodity exchangesregistered with the Forward MarketsCommission (FMC), of which 3 arenational level online multi-commodityexchanges. The number ofcommodities that is tradedon these commodity ex-changes has also registeredan increase over time, fromjust 8 in 2000 to about 120in 2005. Commodity ex-changes in India fall underthe jurisdiction of theForward Markets Com-mission (FMC), a regulatoryauthority which is overseenby the Government of India’sMinistry of ConsumerAffairs and Public Distri-bution.

In the recent past, Indiahas seen resurgence in com-modities futures trading. TheEconomic Survey 2004–05 (aGovernment of India publication) putsthe value of trading in all the commodityexchanges at around Rs 44.95 billion inthe year 2000–01. By 2004–05 this fig-ure touched Rs 5,710 billion (ForwardMarkets Commission estimates). Thephenomenal growth rate of the commod-ity exchanges can be gauged by the factthat volumes in the first 5 months of the current financial year 2005–06 areRs 6,058 billion or 106% of the totalvolumes in 2004–05.

NCDEXThe National Commodity and Deri-vatives Exchange (NCDEX) is the pre-mier commodity exchange in India. Itprovides a world-class online tradingplatform for market participants to trade

in a range of commodities. NCDEX ismanaged by a cadre of talented profes-sionals and has an independent board ofdirectors. It commenced operations onDecember 15, 2003 and is located inMumbai. NCDEX aims at assisting infair price discovery and risk managementof the underlying assets by use of central-ized, transparent, technologically drivenprocesses.

Since its inception, NCDEX has intro-duced contracts in 39 commodities. Thisincludes 34 agricultural products, 2 eachof bullion and base metal products and 1 energy product. It has around 650members with around 490 centers andmore than 6600 trading terminals. Interms of volumes, NCDEX grossed a

peak daily volume of Rs 71. 97 billion(USD 1.67 billion) on August 22, 2005and had an average daily trading volumeof about Rs 38.36 billion (USD 892 mil-lion) in August 2005. It ranks first inIndia and accounts for about 60% ofexchange traded volumes in India.

Ownership structureThe Exchange has eight shareholders:

Canara Bank, a very largedomestic bank with a strongpresence in Southern India’slocal agro markets; CRISIL,the biggest credit ratingagency in India and an asso-ciate of Standard & Poor’s(S&P is the majority share-holder at CRISIL); ICICIBank, the largest privatesector bank and No 2 in the country, technologicallyamong the most advancedbanks in the world; IFFCO,an apex cooperative organi-zation in India with over36,000 cooperatives affili-ated to it; Life InsuranceCorporation of India (LIC),the biggest life assurance

company in India; NABARD, the apexagricultural bank in the country;National Stock Exchange (NSE), thebiggest stock exchange in India andamong the top five in the world by vol-ume; and Punjab National Bank (PNB),a very large domestic bank with a strongpresence in Northern India’s local agro

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NCDEX: The future ofcommodity derivativesIndia is the world’s leading producer in several agricultural commodities and also the world’s largest consumer

of edible oils, pulses and gold. The commodities spot market in India is spread over a vast area – around 7,500

localized markets (known as ‘Mandis’) throughout the country – a challenge to establish a commodity futures

market.

“There are two bigchallenges, first to buildawareness and train marketparticipants in using theelectronic platforms andsecond, to rapidly providelow cost, easy-to-accessfacilities to the farmers.”

Turnover of Commodity Futures Markets (Rs billion)

2001–02 2002–03 2003–04 2004–05

NCDEX 0 0 14.90 2,663

Total 44.95 665.30 1,293.64 5,701

Source: Forward Markets Commission


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markets. The shareholders contributeexpertise in closely related fields such asrisk management (CRISIL), rural banknetwork (Canara Bank in the south andPNB in the north), technology (ICICIBank), agriculture (NABARD), onlinetrading technology and derivative trad-ing (NSE), market reach (IFFCO whichhas the largest number of farm coopera-tives), and expertise in institution build-ing (LIC).

In several aspects, NCDEX has been a pioneering force in the commoditiesmarket.

Launch of indices NCDEX was first to launch agriculture-based indices in India. The purpose is toprovide an indicative index on the sectorwhich can be used for trading, subject toregulations. As of today, the indices canbe traded due to regulations. The indicesare provided to the market participantsonly for information but are being usedas benchmarks by the market.

On May 3, 2005, NCDEX launched a spot agricultural index, the NCDEXAGRI, which has representation from allthe sub-sectors such as cereals, pulses, oilseeds, plantation crops, spices and condi-ments, fiber and other crops. This com-posite index is an equal weighted index.The reference period for the index is theaverage price of the benchmark varietyprevailing during the year 2001. On June1, 2005, two new indices were added, an

agriculture futures index, FUTEX AGRI,and a rainfall index: NCDEX RAIN. TheAgri futures index is constructed on theprices of the nearest month expiry con-tracts for the same basket of commodi-ties that forms part of the spot index.This makes comparison of the twoindices easy. The futures index makes useof a five-day roll over period tosmoothen out the jump at the time ofexpiry of contracts that constitute theindex because of the roll over cost in theindex value. A similar approach is usedin the Goldman Sachs Commodity Index(GSCI). The rainfall index encompassesrainfall at weather stations in Mumbaiand is structured on the basis of pastrainfall data. The rain index can be thebasis for a weather derivative once indextrading becomes a reality on commodityexchanges in India.

Spot prices pollingNCDEX is the only organization in Indiato provide near real time spot prices ofcommodities traded on the Exchange.When NCDEX started operations, therewas no effective way of knowing thelocal prices of agricultural commoditieson a real-time basis. It pioneered the con-cept of polling spot prices for a givencommodity of a certain pre-definedgrade/quality with the help of stringersposted at the ‘mandi’ (local markets)centers. The polling process is analogousto that of LIBOR. The spot prices are

electronically transmitted to a centraldatabase for further processing and“bootstrapping” to arrive at a cleanbenchmark average price. Bootstrappingis a technique employed the world overto arrive at an unbiased benchmark pricefrom limited sample data. The polling isconducted by the Centre for MonitoringIndian Economy (CMIE), a professionaleconomic research organization for agri-cultural commodities. The pioneeringefforts of NCDEX have been commend-ed by the Ministry of Finance, in TheEconomic Survey 2004, tabled in theParliament on July 7, 2004.

Delivery mechanismThe exchange was the first to facilitateholding of commodity balances in anelectronic form very much like cash in asavings bank account and securities in anelectronic custodial account. As per theForwards Contracts Act, 1952, futurescontracts have to be settled by delivery.The concept of electronic balances wasadopted to execute the deliveries with theintention of achieving the same level oftransparency and speed in deliveries as isprevalent in the equities markets. TheNational Securities Depository Limited(NSDL) the largest depository in thecountry, helped in the implementation ofdematerialization of warehouse receiptsinto electronic balances. Subsequently,the exchange has also entered into anagreement with the other depository inthe country, Central Depository Services(India) Limited (CDSL) to enable smoothcommodity settlements.

Certification ExaminationsTo promote the concept of commoditytrading, the exchange has introduced anonline certification exam on commoditymarkets and derivatives (commoditymodule). It is the first commodityexchange to have introduced a Cer-tification Examination. The certificationexam is conducted as a part of NSE’s

NCDEX Trade Statistics

Avg trades Total Avg trading Trading Avg trading per day trades value (Rs bn) value (Rs bn) quantity

2004 22,237 6,706,335 5 1,519 561,716

2005 (Jan–August) 70,584 14,366,178 23 4,709 1,595,673

Source: NCDEX


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13Certification in Financial Markets(NCFM) module of the NSE. Over 5,100candidates have already taken this exam-ination since its inception in August2004. NCDEX is also in the process ofconducting similar exercises orientedtowards bankers. It has tied up withIndian Institute of Banking and Finance(IIBF) for this purpose.

Setting up of National CollateralManagement Services LimitedAs delivery is an integral part of theentire process of commoditytrading, NCDEX has accred-ited various warehouses andlinked up with accreditationagencies to ensure that deliv-ery takes place as per speci-fications of the contracts.However, it has been recog-nized that warehouse man-agement would be a majorchallenge which would haveto be resolved to secure thefast pace of growth envis-aged. At the same time, theexchange is aware that col-lateral management is notpart of its business. There-fore, it took the initiative ofsetting up a new companycalled National CollateralManagement Services Limit-ed (NCMSL) to take care of the issues ofwarehousing, collateral management aswell as to facilitate commodity financeby banks.

Strategic Alliances and partnershipsNCDEX has entered into various strate-gic alliances with the aim of promotingits interests. • Tokyo Grain Exchange (TGE)• Food Corporation of India (FCI), a

Government of India body. FCI carriesout the food subsidy program. It buysdirectly from the farmers at preset

prices and distributes it through thepublic distribution system. Under theagreement, NCDEX will utilize thewarehouse capacity and laboratoryfacilities available with the FCI.

• Indian Agricultural Research Institute(IARI) for advisory services for objec-tive grading in rice, wheat and maize.

• Central Institute for Research onCotton Technology (CIRCOT) forscientific grading of cotton.

• Gas Authority of India Ltd (GAIL) tojointly work towards the development

of a spot market for natural gas in thecountry.

• The International Petroleum Exchange(IPE), Europe’s leading energy futuresand options exchange, to allow Indianparticipants to trade rupee-denomi-nated Brent Crude futures contracts,priced and settled with reference to thebenchmark IPE Brent Crude futurescontract.

Ushering in the future in agriculture80–85% of the exchange’s volume is gen-erated from futures trades in agriculturecommodities. Agriculture and allied sec-

tors account for 21% of GDP and sup-port 57% of the population. In India,most farmers rely on price data from theprevious season to decide on the choiceof crop. This often works to their detri-ment. A season of drought is often fol-lowed by a season of plenty and a glut in production causes prices to fall. Afarmer, who had invested heavily in seedsand capital, finds himself faced with theundesirable situation of falling prices forhis produce and a looming debt trap.With the spread of technology and

awareness, farmers will makeuse of futures prices to decideon the cropping pattern.

By providing a transparentand efficient platform totrade in agricultural prod-ucts, NCDEX has tried toincrease efficiency in agricul-tural marketing. It dissemi-nates futures price datathrough various print andelectronic media. NCDEX isin talks with the relevant gov-ernment offices to display itsticker tapes at rural bankbranches, railway stations,bus stands, and post offices.Kisan or farmer call centershave been set up to dissemi-nate prices through tele-phone. NCDEX has dedicat-

ed a line to price queries from framers.At NCDEX, the thrust has clearly beento strengthen Indian farming and tradingsegments through price knowledge a pri-ori so that there is fair price realization.NCDEX & in association with IARI &NCMSL have set up, on an experimen-tation basis, an information kiosk inRajasthan to provide farmers with a sin-gle point interface for financial servicesand price risk hedge platform at thepoint of sowing of crop so that thefarmer can take an informed decision onwhich crop to grow and also when to sellthe crop. The Information kiosk will

“Empowering the grassroot level participantswith price knowledgewould be the first steptowards enabling themrealizing the benefits from hedging on anexchange platform.”


equip farmers with real time spot andfutures prices of all major agriculturalcommodities & weather related data forfarmers to take any corrective and pro-tective measures. Warehousing relatedinformation likewise would be providedin the days to come. Over a period oftime, NCDEX plans to install similar“Commodity Information Kiosks” acrossall mandis at the regional and nationallevel so as to link the entire physical agri-culture market.

In a short span of less than two yearsNCDEX has managed to change the faceof commodity trading in India. It hasmaintained high standards and set thepace for revolutionizing commodity mar-kets in India. Its influence on the agricul-tural marketing field has been feltthrough better price realization by the

farmers. At all times, the exchange willensure that the measure of its success isnot just its business levels or its financialachievements but the extent to which ithas made a difference and has been able

to benefit the actual user, consumer, andinvestor at the grass root level. This lastmile, which is also the longest one, willbe its focus in the times to come.

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P. H. Ravikumar is Managing Director and CEO of theNational Commodity and Derivatives Exchange Limited.Prior to joining NCDEX, he worked in senior positions atICICI Bank and the Bank of India. NCDEX is an online multi-commodity exchange drivenby professionalism, transparency and the best globalpractices. It is committed to provide a world-class com-modity exchange platform for market participants to

trade in a wide spectrum of commodity derivatives. The Exchange works onsound commercial principles and has achieved break-even level in the very firstfull year of operations. www.ncdex.com

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Multi Commodity Exchangeof India – emerging nameof the emerging economy

India, with a population of over one billion, is primarily a com-modity centric economy where special emphasis is laid on agri-culture, bullion, base metals and, of late, energy products. Theagriculture sector engages about two-third of the country’sworkforce and contributes close to 25% of the nation’s GDP.Bullion (gold & silver) plays an important role as a savings andinvestment vehicle with strong cultural and social valuesattached to it. With all-round development, India is one of thefastest growing economies, having consistent GDP growth rateof 7–8% p.a. A brief sketch will highlight the strong founda-tion that exists in India for a commodity futures market:• Supply – World’s leading producer of 17 Agro Commodities• Demand – World’s largest consumer of Edible Oils, Gold• GDP driver – Predominantly an AGRARIAN Economy• Captive Market – Agro products produced and consumed

locally• Width and Spread – Over 30 Major Markets and 7,500

Mandis • Potential – Value of Production around INR 3,000 billion

and expected futures market potential, around INR 30,000billion (assuming a conservative multiplier of 10 timeswhich, in case of US, is 20 times and also assuming that allcommodities have futures market over a period of time).

In spite of its strengths and maturity, Indian commodity futuresmarket has had a long but plagued history. Till 2003, futurestrading was permitted only at regional exchanges specialisingin a few commodities. Since volumes at the regional exchangeswere abysmally low, the primary objective of futures trading –price discovery – was hardly achieved. Without price discovery,there was a lack of risk management practices.

In order to revive this market, Government of India man-dated setting up national online commodity exchanges andallowed futures trading in a spectrum of commodities.Currently, there are about two-dozen commodity exchanges, ofwhich, three are national and the rest regional. The threenational level de-mutualised online commodity exchangesstarted their operations in late 2003. The performance dis-played by the national-level multi commodity exchanges, sincethen, has been stupendous. The exponential growth hasremoved the chronic lack of liquidity in the market and attract-ed participants from across the country.

Multi Commodity Exchange of India Ltd.An independent, de-mutualised, national multi commodityfutures exchange, MCX (ISO 9001:2000) provides an online,centralized and regulated marketplace for commodity futurestrading. MCX has permanent recognition from Government ofIndia. It functions under Forward Markets Commission regu-

lations, under Ministry of Consumer Affairs Food & PublicDistribution, Government of India. The Exchange is governedby statutory acts, thus assuring integrity of its trading andfinancial practices. The Exchange, through its membership cri-teria and trading rules, safeguards the financial integrity of themarketplace.

Besides Financial Technologies (India) Limited, (FTIL),MCX is promoted by a slew of leading Public & Private SectorBanks. State Bank of India (India’s largest commercial bank),National Stock Exchange of India Ltd. (NSE), National Bankfor Agriculture and Rural Development (NABARD), HDFCBank, and a host of other respected entities make up its pro-moter roster. MCX takes pride in being the industry pioneerand in two years of operation has grown to one of the world’slargest futures exchange in Bullion, being the 3rd largest in Gold and 2nd largest in Silver. It is also the first exchange in theworld to start futures trading in Mentha oil. Strategic MoUswith world’s leading commodity exchanges – New York MetalsExchange (NYMEX), Chicago Climate Exchange (CCX),Tokyo Commodity Exchange (TOCOM) and The BalticExchange, London – have created global platforms for tomor-row. The scope of the strategic alliance covers training, riskmanagement, business development and regulation develop-ment of a vibrant derivatives market.

MCX also enjoys exclusive alliances with the country’s lead-ing commodity trade bodies like Bombay Bullion Association,Bombay Metals Exchange, Pulses Importers Association ofIndia, Solvent Extractor’s Association, UPASI, and IPSTA.

MCX, along with FTIL, has signed up with Dubai Metalsand Commodities Centre (DMCC), an initiative of Govern-ment of Dubai, to set up Dubai Gold & CommoditiesExchange, an International Gold and Commodity Exchange inDubai. FTIL along with MCX and NAFED have joined handsto set-up the “National Spot Exchange” for AgricultureProduce (NSEAP). MCX has also launched India’s first com-posite Commodity Futures Index ‘MCX-COMDEX’.

MCX is the first ever commodity futures exchange in theworld which started futures trading in Crude Oil, Steel &Cashew. The Exchange’s computerised trading network linksthe buyers and sellers and provides them with an efficient pricediscovery system and a platform to hedge risk. The systemensures the best bid and offer for market participants.Presently, MCX has over 1,000 members from over 500 citiesoperating through more than 5,000 Trader Work Stations.

Since its launch, in November 2003, MCX has clockedastounding growth and pioneered development of commoditymarkets. It has widened reach and contributed to informationdissemination, price sharing, spread awareness and educatedmarket participants. By April–September 2005, it has clocked

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a turnover INR 28,98,300.21 million – already 75% higherthan INR 16,62,810.4 million traded in the entire 2004–05financial year. From a launch turnover of INR 8.3 million onNovember 10, 2003, MCX has grown to clock an averagedaily turnover of INR 33,000 million with spurts up to INR48,000 million on some days.

This increase comes from a constantly enriched commoditymix, introduction of new and innovative contracts aligned torespective industry requirements, a robust and efficient tech-nology backbone and growing awareness of a new investmentand hedging mechanism.

Bullion and Energy: Twin strengthsBullion has always been the strength of MCX. The record vol-umes have made it the country’s largest and world’s thirdlargest bullion exchange. India today, is the largest consumer ofgold, with an annual figure of 800 tons. It consumes an addi-tional 4,000 tons of silver. Correspondingly at MCX, an aver-age trade of around 10 tons of gold and 580 tons of silver areregistered daily.

MCX was the first to launch crude oil futures in India. Itreceived enthusiastic response from all end-users of petroleumproducts, petrochemicals and transportation and within a spanof just 6–7 months volumes grew manifold. Today, light sweetcrude oil futures on the exchange trades about INR 15,000 mil-lion per day. This translates to about 6–10 million barrels –almost double the daily crude oil consumption in India. MCXcrude price is now an established reference for Indian markets.

In its efforts to popularise futures trading as hedging toolagainst price fluctuations among importers, exporters, pro-cessors, producers, farmers and other intermediaries, MCX has built strategic alliances with some of the largest trade asso-ciations in commodities eco-system, namely, Bombay Bullion

Association, Bombay Metal Exchange, Solvent Extractors’Association of India and Pulses Importers Association.

The Indian economy will further open up, making domesticindustry more susceptible to commodity price risk. This willcatalyze the domestic players to use market-based risk manage-ment solutions such as derivatives trading for risk avoidance.The true potential of commodity markets will then unfold.

To integrate agricultural markets, provide price informationand create a common price discovery for farmers and otherparticipants in the agriculture sector, MCX, along with FTIL,has joined hands with NAFED to set-up National SpotExchange for Agriculture Produce (NSEAP). MCX have alsotied up with Corporation Bank for “Corp Agriculture ProduceLoan”(CAPL) scheme for farmers. MCX has launched India’sfirst composite Commodity Futures Index ‘MCX-COMDEX’which is now a benchmark index for the market. MCX hasalso announced National Gold Delivery Market in partnershipwith World Gold Council.

Information dissemination has evolved after agreementswith Bloomberg, Telequote, Moneyline Telerate and Reuters,to provide real-time market information to clients, globally.MCX has tied-up with Oster Dow Jones for providing real-time Newswire services to subscribers on its website.

MCX has taken initiative to educate and spread awarenessof commodities futures trading and risk management. FromApril 2004 to July 2005, MCX has offered over 100 trainingprogrammes to nearly 7,000 participants. It has also tied upwith Welingkar Institute of Management and Technology andG B Pant University of Agriculture and Technology to conductjoint courses and organize seminars.

MCX believes in the sustaining strength of India’s tradition-al commodities markets. It applies robust and cutting edgetechnology, building the premier online national exchange forcommodities futures training. It fosters symbiotic alliances,national and global, that will harness and unfold benefits ofthis market, from a few to the many.

Rub

rik

17

MCX Monthly Volume

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50

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Metals Energy Agriculture Polymers

“An independent, de-mutualised,national multi commodity futuresexchange, MCX (ISO 9001:2000)provides an online, centralizedand regulated marketplace forcommodity futures trading.”

Jignesh Shah, Managing Director &CEO, Multi Commodity Exchangeof India Ltd (MCX).

www.mcxindia.com


India? Really? What are you doing inIndia? My partner and I must hear aquestion like this at least once a daywhen we are home in Chicago. I supposeit is natural for our friends and acquain-tances to be surprised. We have beenfloor traders and market makers fortwenty years at CBOT, CME, CBOE,and LIFFE. We have also spent much ofthe last decade trading elec-tronically on equity andfutures markets all over theglobe. So we answer thosequestions by saying “elec-tronic trading is where thegrowth is, and the growthwill be fastest and longest inChina and India”.

Why India? The two most populousnations in the world areloosening the reins on their entrepre-neurial citizens. The media focus fallsmostly on China and the astonishingspectacle of a totalitarian governmentmorphing into a less controlling morecapitalistic form. The story in India isevery bit as exciting and far moreaccessible. The world’s largest democ-racy spent forty years with socialistpolicy and bureaucracy run amok. The“License Raj” put a stranglehold on thebusiness community. The early ninetiesintroduced a period of reform and the resulting growth is remarkable.Outsourcing of jobs to India’s techindustry is well advertised in the press.But, the extraordinary internal growthis often overlooked. India has a hugeand well-educated, upwardly mobilemiddle and upper class. This affluentgroup is demanding and acquiringmore of the comforts of a modern life-style. The result is growth in demandfor consumer goods, real estate andinfrastructure development, powerconsumption and natural resource uti-lization.

Financial markets developmentThe financial markets are under pressureto grow fast enough to attract and allo-cate the resources needed to fund theexpansion of the domestic economy.Fortunately, reform of the financial mar-kets began early in the 1990s. TheNational Stock Exchange of India (NSE)was formed by the government in 1994

in response to the refusal by members ofthe Bombay stock Exchange to clean upand modernize shoddy practices. The all-electronic NSE has been a smashing suc-

cess. India has over 5,000 listed securities,index futures and options, and singlestock futures and options. The NSE isthe world leader in single stock futuresvolume with over 100 different compa-nies covered. Trading volume in indexand single stock futures has grown veryrapidly while options volume has beenheld back by an archaic and burdensome

fee structure. Rationalizationof option commissions andfees will permit explosivegrowth of option volumesduring the next strong mar-ket advance.

Trading environment All the derivative contractsare cash settled with monthlyexpirations. Volume is almostentirely in the front monthuntil the expiration week.

Bid/Ask spreads are reasonable relativeto commission and transaction tax levels.Cash and carry trade is active and theemotional character of the market is

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What are you doing in India?Bruce Lawrence, an experienced former Chicago floor trader, explains why he is now trading the Indian markets.

“The growth will be fastest and longest in India.”

Derivative contract volume on NSE (000)

50 000

40 000

30 000

20 000

10 000

02001/2002 2002/2003 2003/2004 2005/2005 April 2005

Index Futures Index Options Single Stock Futures Stock Options


reflected in the volatility of the futurespremium. Commissions and fees foroptions are based on premium plus thenotional value of the strike. As a conse-quence volume tends to occur only invery near the money options. The inac-tivity in out of the money options resultsin rather ill defined implied volatilitycurves and significant variance of at themoney volatility. This is a very livelymarket.

Registration Investing in India for the long term is a rel-atively straightforward process. One mustregister as a Foreign Institutional Investor(FII) or as a sub-account of an FII. Everylarge brokerage firm will be familiar withthe registration paperwork and costs.Once an account is opened, investing inlisted securities is essentially the same pro-cedure as in one’s home country.

We have chosen the alternative route.We have formed a local corporate entityand are a creating a stand-alone propri-etary trading operation. We were fortu-nate to have an Indian partner with localexpertise. The process would have beenfar more time consuming and costlywithout this local knowledge.

Potential pitfalls …Hurdles still remain for the professionalderivatives trader. The sophisticatedanalytical and automatic execution soft-ware used in the United States andEurope cannot be connected to the NSEsystem. Local regulations make theseauto-execution systems illegal to use. Inaddition there are bandwidth con-straints. Change is on the way, but man-ual order entry is still a requirement.This one issue has kept most of the real-ly large derivative trading firms out ofIndia so far. I have met or talked with

friends at several of these firms and theyare all planning to come to India in thenear future.

… and huge opportunitiesThe NSE recently announced theyexpected volume growth of 70% peryear for several years. Warren Buffett hastalked about an “electronic herd” intoday’s markets that may be prone tostampede. The electronic herd is comingto India and it is adding billions ofpotential members and enormous newopportunities for derivatives traders.

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19

Bruce B. Lawrence

CDLS Consulting

B511 Mega Centre, Sholapur Road

Pune India

[email protected]

CDLS Consulting LLC

300 Drexel Lane

Glencoe, IL 60022, USA

[email protected]

“India has the potential to

show the fastest growth over

the next 30 and 50 years.

Growth could be higher than

5% over the next 30 years and

close to 5% as late as 2050

if development proceeds suc-

cessfully.”

Goldman Sachs,

Global Paper No. 90,

Oct. 2003

“India has come a long way

from its inward-looking eco-

nomic strategy of over 50

years ago. Economic liberal-

ization and the gradual open-

ing up to the world have boost-

ed growth and lifted millions

out of poverty. We argue that

the continuation of the reform

process will allow India to stay

on a high growth path of

roughly 6% per year on aver-

age for the next 10 to 15

years. If reforms were pur-

sued more aggressively, real

GDP growth could reach

7%–8% per year. India will

thus become one of the

fastest growing economies

during that period and the

world’s third largest economy

by 2020.”

Deutsche Bank,

Research, May 2005,

“India Rising: A medium

term perspective”


Creation of the NSEA little over a decade ago, India’s securi-ties market was absolutely third world.There was little transparency. Mosttransactions were offset during two-week settlement periods and a real trans-fer of shares involved clerks pushingaround truckloads of paper shares, witha noticeable percentage of the deliveredcertificates turning out to be counterfeit.

Today, India has a modern securitiesmarket that in some aspects actually sur-passes the U.S. market. India has 5,644listed companies, more than any othercountry in the world. Its leadingexchanges are electronic, and its settle-ment system is a day faster than that ofthe U.S. – T+2 compared to T+3. TheNational Stock Exchange, the country’sleading stock market, handled moretransactions in 2004 than any otherexchange in the world, except the NewYork Stock Exchange and Nasdaq. TheBombay Stock Exchange, the second-largest market in India and the oldeststock exchange in Asia, ranked fifth onthis global list.

How has India pulled off this miracle?The process began just over a decade ago with the government’s frustration infailing to get the BSE, the dominantexchange at the time, to introduce somerelatively modest reforms. In 1992 and1993, the Securities and Exchange Boardof India, India’s securities regulator,asked for two things – first, have the BSEbrokers register with SEBI and second,unbundle commissions from the prices ofsecurities, instead of embedding the com-mission in the price of the security theway OTC dealers do.

The brokers reacted by going onstrike. Not a smart move. The govern-ment countered by creating the NSE inpartnership with several state-ownedfinancial institutions. The new exchangewas all-electronic and transmitted real-time bids and offers to the remotest partsof the country via satellite.

In strictly volume terms, the NSE hasbeen a smashing success. It began tradingin November 1994 and in less than ayear it was doing more business than theBSE. Over the last three years, turnoverhas jumped 69%, thanks to a bull mar-ket in Indian stocks, and today theexchange has twice as much volume asthe BSE.

More importantly, the NSE’s successhas completely changed the nature of thedomestic stock market. It forced the BSEto jump on the electronic trading band-wagon and vastly improved the trans-parency of stock market prices. It alsohas helped broaden the appeal of equityinvesting, with the number of stock bro-kerage accounts growing by 29% lastyear (that’s 5,400 new accounts beingopened each business day) to reachabout six million by year’s end.

Equity Derivatives Take OffSEBI’s main purpose in creating the NSEwas to accelerate the process of reform inthe stock market, but its success also

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Reading the business press, it’s hard to miss the buzz about outsourcing and the amazing growth of India’s

software industry. But has anyone noticed the newfound maturity in Indian derivative markets? In the last sev-

eral years these markets have made a huge jump forward in terms of technology, transparency and trading

activity, and it is clear that the potential size of these markets could be enormous. In part one of this article,

we look at the fantastic growth in equity derivatives trading in India. In the second part, we look at an even

newer trend, the revitalization of physical commodity derivatives after decades of official discouragement. By

Michael Gorham, Susan Thomas and Ajay Shah. Reprinted with the permission of Futures Industry, the maga-

zine of the Futures Industry Association (www.futuresindustry.org).

– The Crouching Tiger

Exploding VolumesEquity derivatives volumes an the National Stock Exchange of India

Source: FIA


created the right ingredients for a boom-ing equity derivatives market, which waslaunched in 2001.

Measured by the number of futuresand options traded in 2004, the NSEranked as the 17th largest derivativesexchange in the world, and the 10th

largest in futures-only volume. Duringthe past several months the value of equi-ty derivatives trading has been more thantwice the value of trading in the under-lying cash equity market.

The vast majority of this trading isconducted by retail participants, a cate-gory that includes small brokerages trad-ing for themselves. Only three percent ofequity derivatives trading is institutional,and of that small amount, almost allcomes from foreign institutional firms.

In the first two months of 2005, theNSE traded 35 times the number of equi-ty futures contracts as were traded onOneChicago, the only U.S. exchange stilllisting such contracts. Why did Mumbaisucceed at single stock futures while theylanguished in the U.S.? Many wouldpoint to a more hostile regulatory envi-ronment in the U.S. But a more impor-tant factor was that Indian traders hadyears of practice trading something veryakin to equity futures.

Until recently, India’s stock marketshad settlement periods that used to be aslong as a month, gradually reduced totwo weeks and then one week beforefinally being transformed into the rollingsettlement we have in the U.S. For exam-ple, a week-long settlement period meantthat a trader could buy and sell largenumbers of stock from Monday onwardsand would only have to deliver or receivedelivery on his net position at the closeon Friday. If the net position was zero,there was no delivery required and hewould simply receive his trading profitsor pay his trading losses. In fact Indiahad a peculiar mechanism, called badla,which allowed traders to carry forwardlarge long or short net positions to the

next settlement period, so traders couldaccumulate sizable positions and avoiddelivery for many months.

This futures-like practice was elimi-nated just before single stock futureswere introduced, so the familiarity withsettlement periods and carry forwardswas transformed into a demand for equi-ty futures, ensuring a fabulously success-ful new product. On the other hand,because Indian traders were not at allaccustomed to the idea of trading abroad market index, equity index futuresgot off to a much slower start and onlynow are beginning to catch fire.

The Rebirth of Physical CommodityTradingWhile exchange-traded equity deriva-tives are a mere four years old in India,the history of futures exchanges for phys-ical commodities goes back to 1875,about a decade after they started inChicago. Cotton was the first product tobe traded on an organized exchange inIndia, followed by a group of oilseeds,then jute, then wheat and then manyother things. These contracts traded onlocal exchanges throughout the country,with markets and prices fragmented dueto the high cost of moving both goodsand information around.

After independence from the UK in1947, however, commodity futures trad-ing came under increasing pressure as thecountry moved down the socialist path.Prime Minister Nehru had watched fromprison as the capitalist countries gotmired in the Great Depression of the1930s while the Soviet Union seemed tobe making significant progress. So whenNehru came into power, five-year planswere in and free markets were out. Thusthe government in 1952 banned cash set-tlement and options trading under theForwards Contract (Regulation) Act,and decided to directly protect farmersby setting minimum support prices for aset of important commodities referred toas “primary commodities”. The ban wassubsequently extended to all forwardtrading after several years of drought atthe end of the 1960s, when suppliesshriveled, prices soared, and a large num-ber of farmers defaulted on their forwardcontracts, with many of these actuallycommitting suicide. The governmentresumed permitting trading forwards ona small set of agricultural commodities inthe 1970s, but the volumes never reachedtheir pre-ban levels. Trading had movedunderground to OTC contracts, whichhad the additional advantage of avoidingtaxes.

Exchange-traded equity derivatives in India and the U.S.

Measured by number of contracts traded in Jan–Feb 2005

United States India

Equity options 196,365,228 70.7% 895,513 6.4%

Equity index futures 53,665,284 19.3% 3,660,393 26.3%

Equity index options 27,345,225 9.8% 633,319 4.6%

Equity futures 242,372 0.1% 8,719,351 62.7%

Total 277,618,109 100.0% 13,908,576 100.0%

Source: FIA and NSE

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Focu

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23All that changed a few years ago whenthe government began liberalizing thecommodity futures sector. SEBI’s author-ity is limited to financial products, so the lead role went to the Forward Mar-kets Commission, a department of theMinistry of Consumer Affairs, Food andPublic Distribution.

In 2002, the FMC decided to encour-age the creation of national electronicexchanges to overcome some of thestructural impediments to the modern-ization of commodity futures, which atthat point tended to be traded on a largenumber of small regional exchanges,which typically had active trading in onlyone or two products. The first exchangeout of the box was the National Multi-Commodity Exchange of Ahmedabad(NMCE), which started November 2002.A year later two exchanges opened theirdoors in Mumbai – the Multi-Commo-dity Exchange (MCX) and the NationalMulti-Commodity Derivatives Exchange(NCDEX), which is partially owned bythe NSE. A fourth exchange, the NationalBoard of Trade in Indore, is on the FMC’slist to achieve national status, but has notyet converted from floor to screen andactively trades only one product.

These markets are still prohibitedfrom using options or cash settlement,two key components of any modernderivatives market, but in other respectsthey are making rapid strides. Today, themonthly traded volume in commodityderivatives in India is around Rs 1 tril-lion (about USD 22 billion). In compari-son, equity derivatives trading, which is almost all at the NSE, is roughly 2.5 times bigger.

The exchanges all list a large numberof products, but see active trading inonly a handful. For instance, NMCE lists61, but had trading in only six during thefirst two weeks of April. MCX tradednine of the 50 listed; NCDEX traded 16of the 39 listed; and NBOT traded onlyone of the six listed.

MCX dominates in precious metalsand crude oil, while NCDEX dominatesin guar (a raw material used to thickenice cream, puddings and other processedfoods) and soy. The much smallerNMCE has found success in jute, pepperand coffee.

While guar seed and guar gum aresmall products in terms of annual pro-duction, their prices are extremelyvolatile, and not surprisingly, this hasresulted in large trading volumes. Goldfutures in India is closely tied to goldtrading at the New York MercantileExchange in New York, and up to 60%of MCX gold trading takes place duringevening hours when the New Yorkmarket is open.

This active and sustained competitionamong the commodity exchanges is incontrast with the equity world, whereliquidity on the derivatives market has allgravitated to a single exchange. It is notyet clear whether this level of competi-tion will be sustained on the commodityfutures side, or whether trading in eachcommodity will concentrate at a singleexchange, as in the U.S.

Can the Rest of Us Play?Foreign entities can trade in Indian equi-ty or equity derivative markets only ifthey are registered with SEBI as aForeign Institutional Investor or as a sub-account of an FII. Who can be an FII?First, the entity must fall within a speci-fied, but reasonably broad, group offinancial institutions, including: pensionfunds, mutual funds, investment trusts,insurance or reinsurance companies,endowment funds, university funds,foundations or charitable trusts, and afew others. Hedge funds and CTAs arenot currently on the list and thus do nothave direct access.

Second, the FII must meet certainfitness requirements, be appropriatelyregulated in their home country, andestablish relationships with a local custo-

dian and local bank. While corporatesand individuals cannot be an FII, theycan be a sub-account of an FII. As of theend of 2004, there were 637 FIIs and1,785 sub accounts of FIIs.

Foreign broker-dealers and futurescommission merchants can gain access toIndia’s equity derivatives markets bybecoming a locally incorporated broker-dealer. More than 15 foreign brokershave taken this route, set up localsubsidiaries and become members of the

Top 10 commodities traded on Indian futures exchanges

Measured by value of turnover for the two weeks ending April 15

Name Amount

Guar $4,524,942,870

Silver $1,985,486,746

Soya $1,489,609,232

Gold $560,962,066

Urad (Black Legume) $490,847,806

Chana (Chick peas) $355,207,952

Crude Oil $290,182,815

Mustard Seed $286,663,620

Sugar $230,895,795

Cotton $185,155,393

Note: official sources do not provideinformation on the number of contractstraded. The data on the value ofturnover was obtained from a reportwhich is released every other week bythe Forward Markets Commission.Local currency values were translatedinto dollars at Rs 43.76 per USD, theaverage exchange rate during the two-week period ending April 15.

Source: Forward Markets Commission


NSE, according to NSE statistics. Theyinclude ABN Amro, Citigroup, CLSA,Fortis, HSBC, JP Morgan, Merrill Lynch,

Nikko Capital, Refco and UBS. As localbrokers, these entities can execute ordersfor both local and foreign customers, as

well as engage in proprietary trading.Foreign individuals or corporates can gainaccess by having a sub account with a FII.

There is one other strategy by whichinterested foreign parties have gainedexposure to Indian equity derivativeswithout becoming an FII or tradingthrough an FII subaccount, and that isthrough an over-the-counter instrumentknown as a participatory note or PN.The process is simple. An FII takes aposition in the Indian market, then issuesa PN with the same economic value to anoffshore investor. This type of “back-to-back” transaction accounts for a signifi-cant portion of the total foreign invest-ment in India’s equity markets, with esti-mates ranging from 20% to 25% of totalFII activity. In January 2004, SEBI issuedan order permitting the sale of PNs onlyto entities meeting certain criteria relatedto their financial strength and home-country regulation. In practical terms,almost any major financial institutioncan use this route to gain exposure to theIndian equity markets, according to bro-kers active in this business.

It should be noted that the Com-modity Futures Trading Commission has

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Interpreting Those Strange Indian Numbers

As long as you get your information filtered through the Economist orFinancial Times or Wall Street Journal, you will not need to know the follow-ing. But if you ever pick up an Indian newspaper, visit an Indian website or tryto do fundamental analysis on an Indian stock, take note.

Americans grew up with hundreds, thousands, millions, billions and, if wewent far enough in school, trillions and some other things I don’t use orremember. But unless we’re talking about astronomy or the national debt, wecan get by with the first three names of numbers. And when we write num-bers, we separate them with commas into groups of three, starting from theright. Like the earth is 93,000,000 miles from the sun.

Indians grew up with lakhs and crores. A lakh is 100,000 and a crore is 100 lakhs, or 10,000,000, though I put the commas in American, not Indianstyle. They do a different comma thing which grows naturally out of the crore-lakh stuff. Going right to left, Indians group the first three numbers just likewe do, but after that, everything is in groups of two. The earth, in India, is9,30,00,000 miles or 9.3 crore miles from the sun.

Quick test. What was global futures and options trading volume last year?If you read this Magazine, you would say 8.9 billion, or 8,900,000,000 con-tracts. If you asked a guy walking down the street in the financial district ofMumbai, he’d say 890 crore, or 8,90,00,00,000 contracts.

The leading contracts on India’s 3 major multi-commodity exchanges

Measured by number of contracts traded in Jan–Feb 2005

MCX NCDEX NMCE

Silver $1,526,718,464 Guar $4,491,483,090 Raw-Jute $31,631,627

Gold $516,055,759 Soy $603,603,748 Pepper $25,690,128

Soy Oil $438,660,878 Urad (Legume Black) $490,847,806 Coffee $25,281,079

Crude Oil $290,182,815 Silver $458,768,282 Rubber $11,930,987

Guar Seed $14,533,821 Chana (Chick Peas) $355,207,952 Cardamom $1,974,406

Note: official sources do not provide information on the number of contracts traded. The data on the value of turnover was obtained froma report released every other week by the Forward Markets Commission. Local currency values were translated into dollars at Rs 43.76per USD, the average exchange rate during the two-week period ending April 15.

Source: Forward Markets Commission Fortnightly Dissemination of Data


not yet provided a Part 30 exemption toany exchange in India. Part 30 exemp-tions, which greatly facilitate cross-border trading by permitting members of foreign futures exchanges to solicitU.S. customers, have been granted formost of the major market centers, includ-ing Australia, Brazil, Canada, France,Germany, Hong Kong, Singapore, Spainand the U.K. (In the case of Japan, thePart 30 exemption applies only to theTokyo Grain Exchange.) The CFTC willgrant a Part 30 exemption only if theforeign regulator meets certain require-ments and shows that it exercises “equi-valent” regulation.

In the case of futures on physical com-modities, neither FIIs nor even domesticfinancial institutions are currentlyallowed to participate. But the rebirth ofthe commodity markets is recent,

reforms are being done gradually, andthere have been discussions about loos-ening these restrictions.

Can Indians play in our markets?Until recently, the government imposedsevere restrictions on outbound invest-ment because of a shortage of foreignreserves. India now finds itself in a com-pletely different position with $125 bil-lion in foreign reserves, the fifth largestin the world. So last year the ReserveBank of India, the country’s centralbank, raised the amount of funds thatIndian citizens could invest abroad to$25,000, which is three times the averagemiddle class salary.

ConclusionShould we want to get in? In mostemerging markets, the internationalinvestor finds relatively illiquid and

unsophisticated securities markets. Notso in India. Markets in equity derivativesare tight, liquid, and transparent. Thereare sound clearing and settlementprocesses, topped off by active marketsin a range of modern products like stockfutures, stock options, index funds,ETFs, index futures and index options.The spot and derivatives markets have asingle regulator, SEBI. And the Indianeconomy is dynamic. So as barriers con-tinue to fall between the two countries,India should prove an increasingly inter-esting market in which to participate.

This article first appeared in the FuturesIndustry magazine. We thank the editorfor the kind reprint permission.

Michael Gorham is director of the IIT Center for Financial Markets at the Illinois Institute of Technology.

Susan Thomas is professor at the Indira Gandhi Institute for Development Research.

Ajay Shah is consultant to the Indian Ministry of Finance.

The authors wish to thank Bikram Chandra, an MS candidate at the IIT Center for Financial Markets, for valuable assistance.

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26th International SFOABürgenstock Meeting,September 7th–10th, 2005

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Wednesday, September 7, 2005The 26th International SFOA Meeting at Bürgenstock literallygot off to a roaring start when the Royal Air Force AerobaticTeam, the Red Arrows, delivered a stunning performance ofaeronautic prowess against a majestic backdrop of snow-capped Alpine peaks. It was certainly an auspicious start towhat promised to be an interesting conference, even by theSFOA’s fabled high standards. This year’s meeting was hostedby the City of London represented by an array of companiesand organizations, which literally moved heaven and earth topresent such a brilliant display.

SFOA Chairman Paul Meier welcomed this year’s meetingparticipants in the refurbished conference room of the PalaceHotel, which conference veterans were quick to note nowfeatures air conditioning. Mr. Meier pointed out the appropri-ateness of the demonstration of precision flying offered by theRed Arrows for the SFOA Meeting. The qualities that make asuccessful jet pilot are similar to those that lead to success inthe derivatives market: consistency, innovation and precise riskmanagement. To accommodate the growing success and popu-larity of the Bürgenstock meeting, an extra day was added tothe event to allow more time for panel discussions and socialinteraction.

Gerhard Odermatt, Director of the Canton of Nidwalden,the Swiss canton in which Bürgenstock is located, stepped upto the podium to welcome the meeting participants. He wasfollowed by Roy S. Leighton, Chairman of Nymex Europe,Ltd., representing the City of London, this year’s conferencehost.

The keynote address was given by Alan Yarrow, Chairmanof LIBA – London Investment Banking Association. In whatwas surely the opening shot of the conference, he presented hisview of “Financial Markets in Tomorrow’s World”, or rather,the view of this particular association of market users. Hebelieves the most significant future issues include ensuring suf-ficient capital, European financial market reform, the loweringof exchange fees and user governance in a consolidating world.While LIBA generally prefers to pursue quiet diplomacy, theyseem to be adopting a more vocal stance regarding the issue ofmarket consolidation and in particular, the lack of progress inthe reduction of exchange fees.

The subsequent panel group was quick to take up the gaunt-let and the diverging interests of market users, clearing housesand exchanges soon became clear. In answer to moderator RoyLeighton’s provocative two-part question – Are exchanges tooprofitable and is demutualization the stepping stone to greaterefficiency? – Michael Spencer, CEO of ICAP plc, clearly statedthat he does not see a return to the old world of mutualism. Hebelieves that demutualized exchanges are better equipped tomove forward, though he does admit that the headiness of theearly days of privatization has waned. David Hardy, GroupChief Executive of LCH.Clearnet Group Limited, offered hisviews from the aspect of clearing. He too sees remutualizationas infeasible, however opined that a compromise must befound between the interests of customers and shareholders. Heoffered LCH.Clearnet’s constitution, which stipulates the con-sideration of customers’ interests in all the company’s activities,as a template for moving forward, a point upon which evenMr. Yarrow agreed. However, not all were in agreement withthe keynote speaker’s views regarding lower exchange fees,

Amazing …

Allan Yarrow during his keynote speech.


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particularly George Gero, Board Member of the New YorkMercantile Exchange, who expressed the opinion that loweringfees will not be useful in the long run and could ultimately leadto uncompetitive exchanges. Moving on to the topic of clear-ing, H. E. Alexis Lautenberg, Swiss Ambassador to the UK,reflected on the rapid movement to a global marketplace overthe past 20 years. He pointed out how the efficiency of the sys-tem is having an increasing impact on the global economy, andfeels that governments missed the opportunity to achieve asense of global regulation, which now seems to be increasinglyhindered by the current bottom-up approach.

At the Eurex press dinner, held at the Bürgenstock GolfClub, CEO Rudolf Ferscha shared the challenges Eurex hasexperienced thus far in 2005. He provided an upbeat update ofthe company’s antitrust lawsuit against the Chicago Board ofTrade and CME, a view likely not shared by said companies.Mr. Ferscha enumerated an impressive list of products in thepipeline, including the launching of a new 30-year future ongovernment bonds. In response to Mr. Yarrow’s earlier criti-cism of the reluctance of exchanges to lower fees, Mr. Ferschainsisted that “Eurex delivers the lowest derivatives exchange inthe world, and the gap is widening”. Whether this went downwith the press corps as well as the fine meal they enjoyedremains to be seen.

All in all, the 26th International Meeting at Bürgenstock wasoff to a rousing start.

Thursday, September 8, 2005The second day of the 26th International SFOA Meeting inBürgenstock greeted the participants with golden sunshine and

glorious views over the Vierwaldstättersee. Those who resistedthe temptation to go sightseeing were rewarded with a day fullof captivating panel discussions.

Jean-Marc Felix, Head of Communication and Member ofthe Executive Committee of the Board, Swiss BankersAssociation, started the session with an introduction to theimpressive world of Swiss banking. Banking is a tradition soembedded in Swiss culture that one cannot properly view itoutside the context of the nation as a whole. With its phenom-enal infrastructure, its climate of adaptability and legendarySwiss quality and efficiency it is little wonder that Switzerlandis among the world’s top banking locations.

The first panel discussion addressed the topic ChangingMedia and Derivatives.

The eloquent Werner Vogt, Media Spokesman for SWXSwiss Exchange launched the discussion by commenting onmedia prejudice, illustrated by a story running this morning inthe local press regarding the Red Arrows flight display enjoyedby the SFOA meeting the previous day. Apparently, the localSwiss cows and chicken failed to appreciate the “entertainmentfor 300 bankers”. With news of such caliber demanding mediaattention it is natural to wonder whether journalists have thetime to properly report on derivatives. Claudia Gabriel-Schneider, Economic and Financial Editor of the venerableNeue Zürcher Zeitung, pointed to the jungle of informationthat must be weeded through to find any real informationabout derivatives. Herbert Skeete agreed that it can be chal-lenging to stay fully informed when new instruments are beingintroduced on a daily basis. Douglas Trainer, a Partner atLuther Pendragon, spoke of the challenge of overcominghistorical perceptions of the industry, which still impact theThe Chicago connection …

Difficult to balance the goodies …


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29public mindset. The complex nature of derivatives leads to adefault to comfortable concepts. Madeline Boyd, SVP ofExternal Affairs at NYMEX, sees one of the biggest challengesin area of education, which her organization fosters through itswebsite, workshops and seminars, by providing access to spe-cialists and by keeping ahead of the onslaught of new products.John Lothian, Editor & Publisher of the renowned JohnLothian Newsletter, admitted that the news cycle today is sofast that even knowledgeable journalists find it hard to keepup. As Werner Vogt stated so succinctly, “nobody wants toadmit that they don’t know”, while Mr. Trainer advised themeeting, “keep your friends close and your journalists closer”.

After the coffee break, the second panel addressed the ques-tion “Has technology delivered?” Panel moderator, CliveFurness, Managing Director of Contango Markets Ltd., gaveeach of panelists time to talk about whether technology hasindeed delivered in his or her organization. Bruce Goldberg,Chief Marketing Officer at the ISE, sees technology as being inan evolutionary process in which it must be more expedientlyimplemented; and become less costly to be maximized/opti-mized. Kevin Ashby, CEO of Patsystems, said that companiesmust innovate to move further up the value chain. He feels that today’s patent-driven world hinders cooperation. TimGeannopulos, EVP Global Sales at Trading Technologies, acompany for which the word patent is not exactly SwissGerman, insisted that protection of innovation keeps his com-pany from cannibalization. He pointed out that it is five timesmore expensive to innovate than it is to copy. John Oddie,Director of Software Engineering at Euronext.liffe, feels thatthe patenting organizations do not really understand what theyare patenting. And Christian Schild, Head of Global Sales forRTS Realtime Systems AG, views patents as a catalyst to inno-vate, if only to stay one jump ahead of the patent process.Technology may have delivered, but it also bears new chal-lenges in its wake.

Attendance was up markedly for the first afternoon paneldiscussion, “China & its influence on Asian development”.Well at home in the world of emerging markets, moderatorPatrick Catania, Member of the SFOA Board, spoke optimisti-cally of how the world financial markets are gearing up forincreased Asian activities, while markets in Asia continue toopen, modernize and join the global marketplace. He intro-duced Ji Xiang Yu, Deputy General Director, Department ofFuture Supervision, China Securities Regulatory Commission.Through his masterful interpreter, Mr. Ji characterized theChinese derivatives market as moving from an initial period ofwild growth into a subsequent period of consolidation. Chinacurrently has over 180 brokerage firms, of which 22 areauthorized to trade overseas. Following the heady volatility

of the early years of derivatives trading in China, the statecouncil issued provisional regulations which are driving themarket’s consolidation phase. Mr. Ji modestly admitted thatcompared to the developed world markets, China’s futuresmarkets are still in their infancy. However, China’s track recordin other markets leads one to conclude that this is a nation offast learners. Now if we could just get him to smile …

Joining Mr. Ji from China was Wang Lihua, Chairwoman ofthe Shanghai Futures Exchange. Mrs. Wang said that Chinaneeds a futures market to encourage future growth, which hastaken off in an even more impressive fashion since its WTOadmission. While the Shanghai Futures Exchange remains tiny,trading in just four basic commodities, perhaps being smaller isbetter when reaching tentatively for basic transparency andgreater efficiency. Yet, even at this early phase of development,it is not uncommon for Shanghai metal prices to impact pricesin London markets, an indication of the market’s maturation.Also on the panel was a representative of the world’s largestfutures market, Falsafi Arman, Managing Director, CMEEurope & Asia, which has been a presence in Asia for over 20 years. CME is in various stages of development through-out Asia and sees itself as a partner that can help developmentof the Chinese futures market. Nick Ronalds, Director, ABNAMRO Futures Group, recalled witnessing first-hand theastounding growth of the Chinese futures market, from zerofutures exchanges in 1989 to 55 in 1995. He highlighted thephenomenal strength of the Chinese copper market, which hasboomed since 2003. While the LME remains the benchmark in Asia, the Chinese markets are making themselves felt. Withthe panel opened for questions, Alan Griethuysen, asked Ms. Wang the question on most everyone’s minds: When we be

The daring Red Arrows with Paul-André Jacot, Roy Leighton,Paul Meier and Michael Spencer (from left to right).


allowed to trade on your exchange? Ms. Wang disarminglystated that at our exchange we look forward to welcoming you,which when translated literally from Mandarin might wellmean “not anytime soon”. Mr. Ji added inscrutably, the time isnot yet right”.

Rounding off the discussion for the day was the question,“Will the commodities boom go on?” Panel moderator DanielHodson, Chairman of the University of Winchester, asked thepanel consisting of both investors and exchange representativesto address this issue of interest to most conference attendees.Swiss investor Thomas Della Casa, Head of AlternativeInvestment Research, sees the market at a point of fundamentalchange with increasing demand and abundant liquidity provid-ed by hedge funds. P. H. Ravikumar, Managing Director andCEO of the National Commodity & Derivatives Exchange, isbullish about future prospects for derivatives in India, thoughthe market is currently limited to smaller traders to avoidingoverheating. Joseph O’Neill, SVP of the New York Board ofTrade, agrees that the demand-driven market will ensure con-tinued growth, fueled by developments in Asia. AnthonyBelchambers, CEO of the Futures and Options Association,provided a more bearish view, pointing out the various issuesthat could potentially weigh on the boom, such as regulatoryprejudice and the persistent perception of commodities as high-risk derivatives. Driving the bear to the edge of the chasm wasHeiko Thieme, Chairman of American Heritage ManagementCorp., who envisions oil becoming the primary commodity ofthe 21st century, while gold declines to relative obscurity. In theshort-term, he predicted that oil prices have reached the highwater mark and sees no rationale for the current high prices.Tara Kimberly, CEO of Four Winds Capital Management,took a more bullish tact when she expressed her conviction thatthe boom will indeed continue, though she cautioned that thereis a need for an increased focus on market users.

Friday, September 9, 2005The weather gods smiled once again on the third day of the 26th International SFOA Meeting in Bürgenstock, lifting theclouds and rain of the night before and ushering the day in withsunshine. Despite the evident toll exacted upon the participantsby the meeting’s traditionally fine evening social activities,attendance was good in the conference room of the Palace Hotel.

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CNBC Europe Brings Live Coverage for the Second Year Running

By CNBC Europe Reporter, Dan Scott

With commodity prices soaring, a flood of new con-tracts coming to market, and consolidation attemptsafoot within the industry, getting a chance to mix withthe dealmakers of the derivatives industry is one wedidn’t want to pass up.

Our live and exclusive coverage of this year’s con-ference started off in the midst of wrangling over the London Stock Exchange. Pan-European bourseEuronext, keen to appease regulators before making abid for the LSE announced it was to reduce its stake inLCH.Clearnet and David Hardy their CEO was able togive our viewers an immediate reaction and inside viewon the implications this would carry.

Commodity and in particular copper prices have seena surge in prices recently prompting wild speculationabout the causes. In an exclusive interview with CNBCEurope, the CEO of the London Metals Exchange dis-missed city rumors on price manipulation and discussedthe impact of the recent weather related price fluctua-tions.

Rudi Ferscha the CEO of the worlds biggest deriva-tives exchange agreed to a candid discussion about thedifficulties that EUREX has faced taking on the incum-bents of the US derivatives markets. His views were re-inforced by comments made later in an interview withthe futures industry association which laid some blameon the lack of access to US markets.

Had the Chicago Board of Trade not been in its quietperiod ahead of its IPO, I’m sure we would havereceived an energetic response from CEO Bernie Dan.We look forward to having him on the show next year.

Sometimes it is tough to get attention …


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Discussed in Friday’s first panel, the provocative topic of“Exchange traded & OTC – Convergence or Contradiction?”Moderated by Richard Metcalfe, of International Swaps andDerivatives Association Inc. in New York, the panel addressedthe issue of how these two trading modes stand in relation toone another. Garry Jones, CEO of ICAP Electronic Broking,Europe, cautioned that the lines have blurred between the two.They share common interests, such as the largest financial insti-tutions, which are providers of liquidity in both. The adoptionof electronic trading systems in OTC companies means thatthey are beginning to take on the appearance of exchanges.John Foyle, Deputy CEO at Euronext.liffe, sees the relationshipbetween exchange trading and OTC as a symbiotic one, inwhich they act as parallel markets which are not necessarilyconverging, but which do share common characteristics, suchas external clearing. William Brodsky, Chairman and CEO ofthe Chicago Board Options Exchange, sees this symbiotic rela-tionship as one factor that is fueling tremendous growth. On amore cautionary noted, however, he added that you cannotpreordain how things will develop, you have to rely on thecreativity of customers. Markets are not static situations.Representing the regulatory side, Sharon Brown-Hruska,Commissioner at the Commodity Futures Trading Commissionin the US, was refreshingly candid in her remarks. She notedthat the CFTC’s sister commission, the SCC, has grappled withthe issue of market fragmentation and found mixed evidence as to whether internalization is detrimental to customers ormarkets. Mr. Brodsky, added that market fragmentation is notnecessarily a bad thing. If markets are price improving, thenorder flow will increase, or in other words, if you build it theywill come.

After the coffee break, the second panel took on “Hedgefunds – a discussion of key industry issues”. Panel moderator,Nicola Meaden-Grenham, Founder and CEO of DumasCapital, Ltd. underlined the veritable explosion of hedge fundsin recent years with impressive facts and figures. The industryitself is growing increasingly institutionalized and democratic.Bruce Ruehl, President and CIO of Gleacher Fund Advisors,sees an interesting time in the hedge fund business in general,one in which a disparity of return and a variety of regulatoryissues make static strategies unworkable. Hans-Jörg Baumann,Chairman and Senior Partner of Swiss Capital Group, believesthat in all aspects, size matters, when it comes to markets, inbusiness and in terms of product risk. Any time you enter amarket with substantial funds, you immediately impact thatmarket. Regarding the question of leverage, Mr. Baumannbelieves the level of leverage has decreased in the hedge fundbusiness in recent years. The banks, which are heavily regu-lated, exercise the greatest leverage today. James Proudlock,Partner at MPC Investors Ltd., sees a need to separate the riskmanagement side of the hedge fund business from the actualtrading. He considers hedge funds to be self-regulating.Without returns, funds simply close. Mr. Baumann counteredthe common perception of hedge funds as a risky business anddrew a parallel to the Red Arrows Flight display viewed onWednesday. Despite the occasional crash, commercial air travel is widely considered to be safe. No airline pilot woulddream of attempting to take risks that are daily practice forRed Arrow pilots. They are specialists, qualified to take suchrisks because they are aware of the variables. To successfullynavigate the skies of hedge funds also requires specializationand qualification. It is a complex world, not for the faint ofheart.

Some discussions are lighthearted …

… while others seem very serious.


After the lunch break, the third panel addressed the issue of“New products”. Moderator Brendan Bradley listed severalcommon conceptions about new products, including the highcosts of R&D, the opinion that shareholders should bear thecost of development and that products must be instantly fun-gible. The panel’s sole representative on the broker side, JohnMathias, Director at Merrill Lynch, sees a recent leveling off ofproduct introduction in comparison to 5–6 years ago, where itseemed nearly out of control. He feels that exchanges havelearned to listen to customers and even went so far as to sug-gest there might even be too few products in the pipeline today.Simon Heale, CEO of the London Metal Exchange, added thatmany “new” products are not really so new, but are furtherrefinements of existing ones. The discussion then veered into a culinary analogy. Mr. Heale chided Joe Raia, Vice Presidentat NYMEX, for what is perceived to be that company’s“spaghetti” approach to new products with cleared OTC prod-ucts, likening it to throwing a plate of pasta at the wall and see-ing what sticks. He contrasted that approach with LME’s moremethodical, i.e. slower, “potato” method with exchange tradedproducts, carefully probed with a fork to check that they arethoroughly baked before consumption. Mr. Raia, however, washaving none of this, and insisted that NYMEX ran a full rangekitchen offering both types of dishes. Saving the panel fromfurther spiraling into questionable food analogies, Peter Reitz,Member of the Executive Board at Eurex, pointed out thatboth the end-user and the FCM’s must be considered andinvolved in a new product launch to ensure success. You haveto bring in the right mix of people. And to dip back into to thefood analogy, while too many cooks may indeed spoil thebroth, consulting only with the kitchen staff is not a very effec-tive method of product development. He admits that there is nosecret recipe for successful product development, but there arenumerous proven ingredients, including extensive customercommunications, education all down the line, timing of thelaunch, and naturally, a pinch of luck.

Following the coffee break, the conference was treated to aninteresting keynote speech entitled “Ecology and derivatives –the way forward” by Eric Bettelheim, Chairman of SustainableForestry Management Limited. A Bürgenstock veteran, return-ing now after a considerable absence with a new sense of pur-pose and direction. Inspired at Bürgenstock by Richard Sandor,he has gone on to partner with him in a creating a venture thattrades in stored carbon credits. Mr. Bettelheim made an impres-sive presentation that graphically illustrated the pace and scaleof our planet’s natural resources, which have been historicallyconsidered to be unlimited, including air, water, energy, waterand biodiversity. As the human population continues to grow(6 billion now, projected 9–12 billion in 2150), competition for

limited resources will increase. This makes a strong businesscase based on simple supply demand, one that markets cannotignore. While the new emerging markets may seem exotic, theydo embody a real and current value.

The subsequent panel discussion, moderated by SteveZwick, Editor of Futures Magazine, offered a tangible glimpseof the future which is already at our doorstep. Adoption of theKyoto Treaty by the EU has fueled the growth of CO2 credittrading exchanges and other schemes to enter this interestingemerging market segment. Peter Koster, CEO of the EuropeanClimate Exchange, and another Sandor-inspired entrepreneur,views global changes from a business perspective and envisionshis current activities as a European petroleum exchange grow-ing into a full range of eco-products. Hans-Bernd Menzel, CEOof the European Energy Exchange, called this new field thebeginning of a revolution, one that he hopes will contribute toa better world. Giorgio Szegö, Chairman of IPEX, the ItalianPower Exchange provided a rather startling view of the renu-clearization of planet Earth as perhaps the only viable way toprovide a sustainable source of power. According to Mr. Szegö,while industry is the popular whipping boy for climate prob-lems today, the greatest share of CO2 to the atmosphere isemitted by rice fields. He advocates a new focus on the prob-lem of electricity storage and the issuing of correspondingcertificates. The various views and approaches of the panelmembers directly involved in the so-call eco-markets underlinethe fact that it is still early days in this new field. Mr. Bettelheimsaid that it is uncertain whether there is enough liquidity andvolume to ensure the success of many of these new eco-deriva-tives, but it would seem that some movement, even if fragment-ed is better than none at all. The rate of development willdepend on political pressure according to Mr. Bettelheim, whoalso feels that George Bush was right in rejecting Kyoto, but iswrong in not seriously addressing this issue. We are amidst avery interesting experiment to see if the private sector canaddress this major issue that confronts the entire world.

Saturday, September 10, 2005The Palace Hotel conference was full for Saturday’s greatlyanticipated Crossfire, skillfully moderated as always by PatrickYoung, CEO of erivatives.com and Chairman of DerivativesVision, who soon had the audience laughing with his rapid-fireand highly entertaining soliloquy. In a wide-ranging and inter-esting discussion of the some of the most burning issues facingthe derivatives markets today, he asked a series of probingquestions that challenged the high-powered panel to providethough-provoking insights. The panelists included:– John Damgard, President of Futures Industry Association

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33– Heiko Thieme, Chairman of American HeritageManagement Corp.

– Antoinette Hunziker-Ebneter, Member of the ExecutiveBoard, Julius Baer Holding Ltd.

– Paul L. Doody, Global Head of Sales and Trading Products,Reuters S.A.

When Mr. Young asked the panelists why the US is not morewilling to allow other markets in, he turned to John Damgard,who countered that foreigners can easily buy US products andthat it can be equally tough for US customers to participate inforeign markets. Antionette Hunziker-Ebneter described the USmarket as “protectionist”, but also sees movement towards anopening. Heiko Thieme scoffed at the notion that Americansare open to internationalization, pointing out that 70% ofAmericans don’t even possess a passport, a claim that can alsobe made by 50% of the members of congress, leading him tocall the US “somewhat of an emerging market”.

John Damgard commented that Eurex seems ready to beata hasty retreat back to Europe. He feels that the slow pace ofglobal market integration among the derivate exchanges is duein part to regulatory issues. The US market is the largest, mostopen market in the world that has until recently enjoyed avirtual monopoly. The US regulatory authorities have beenslow to acknowledge the quality of foreign regulation, andwhile the regulatory scheme is relaxing, it will probably be toolate to save Eurex’s attempted foray into the US from goingbust. However, he acknowledges that competition is essentialto the business. Heiko Thieme suggested that we all regulateourselves. He sees a trend towards a sort of criminalization ofrisk-takers, as if taking risk makes one suspicious. He fears it

could mean the end of entrepreneurship in the US. AntoinetteHunziker-Ebneter pointed out that this is not just a problem inthe US, in Switzerland too there is far too much paperwork andbureaucracy, which is ineffective and costly. She feels that valuecan still be found in the US, which remains the world’s liquid-ity center. Mr. Thieme cried out, “Go East young man!” wherehe sees the greatest opportunity through less regulation andmore risk. Paul Doody, speaking from an information pro-vider’s point of view, welcomes regulation, which he believescreates an opportunity. Patrick Young suggested that a regula-tor clamp-down might bring the speculator boom to a halt, asthe speculators move to freer markets. However, Mr. Thiemepointed out that you always have boom and bust when volatil-ity increases and that common sense dictates some regulation.He sees speculators as serving a purpose at the margins, but asa danger when they begin driving the market.

Then followed a discussion of markets. Patrick Youngwondered why Reuters does not move into the clearing busi-ness. Paul Doody replied that Reuters prefers to retain aneutral stance, but is moving towards becoming more of a hub.Heiko Thieme agreed that Reuters / Bloomberg better serve theindustry by remaining neutral. Mr. Young noted that Reutershas basically decimated the open outcry system, yet in a devel-opment that seems to counter this trend, Nymex is opening anew open outcry exchange in London next week.

Other topics included a riveting exchange about contempo-rary men’s business fashions and rationalization, leaving one towonder if there might not be some mysterious link between thetwo. Mr. Doody’s vested interests clearly lie in less rationali-zation, the more exchanges the better for Reuters. WhileAntoinette Hunziker-Ebneter admitted that she has no crystal

David Hardy in plain action during auction of flight suit.

Enjoying David Hardy’s auction.


ball, she pointed out that the first to consolidate will have aclear advantage. John Damgard sees fewer mergers happeningin the US due to the preponderance of lawyers, the justicedepartment and the FTC. However, he noted, the CME issitting on a pile of money and is definitely in the mood toacquire.

On the topic of how much shareholder politics influence thedrive towards consolidation, Heiko Thieme noted how share-holders need only hold a stock for one minute to have a vote.He likened this situation to nation states, in which visitors tocountries do not automatically receive voting rights. Citizensthemselves must be at least 18 years of age to vote, giving themtime to mature and become responsible. He argued that asimilar system should be introduced in companies as well.Protecting national interests led into a discussion of theprospects of a non-European purchase of the LSE. JohnDamgard noted that the LME is a British national treasure andthat political concerns were sure to play a considerable role inits ultimate fate. Heiko Thieme agreed, pointing out theimmeasurable psychological value the LME embodies. PaulDoody disagreed and compared it with the recent demise ofnational airlines and how Switzerland seems to have gottenover the loss of its flag carrier. Antoinette Hunziker-Ebneter

believes Europe’s financial center will remain in London.Noting that the City’s demise has been predicted many timesbefore, Patrick Young believes that its advanced level of inter-nationalization and generous tax laws will continue to keep ita major global player.

The 26th SFOA Bürgenstock Meeting came to an officialclose with words of thanks and appreciation from SFOA pres-ident Paul Meier. While some hit the links for a round of golf,others prepared for the evening’s gala dinner, while still otherscaught funiculars, boats, trains, buses and planes for the longjourney home, down from the lofty and noble heights ofBürgenstock.

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Special offer – Red Arrows CD

The opening of our last Bürgenstock conference was avery special event: the breathtaking aerobatics show ofthe Royal Air Force Red Arrows. A special CD was produced with pictures from thatshow and is available for CHF 50 minimum. Proceedswill be donated to the MacMillan Cancer Fund, a char-ity supported by the Red Arrows in memory of theirfriend and colleague Matt “Jarvo” Jarvis who died ofcancer this spring. This CD will bring back lots of memories to all thosethat attended (and lots of fun to those that missed thisspecial event!) To order please send a check in the amount of CHF 50(or equivalent) minimum to: SFOA, 18b rue du Gothard,PO Box 325, CH-1225 Chene-Bourg/Switzerland Or make a bank transfer in the same amount orequivalent to our bank account: UBS AG, Geneva AcctNo. 240-461.726.00X (CHF) or .60T (USD)

Special offer – Red Arrows CD

Michael Brewer, Word+Image, Zufikon (Text)

SFOA Conference Journalist for Swiss Derivatives Review

Website: www.wordandimage.ch

Email: [email protected]

Max Hermann, Fachfotografie + Werbung, Stansstad (Photos)

Email: [email protected]

One for the ladies …


Proceedings of theEmerging Markets Forumat the 26th SFOABürgenstock Meeting

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The Emerging Markets Forum (EMF) at Bürgenstock 2005 wasorganised under the auspices of the Association of FuturesMarkets (AFM) and the SFOA and expertly chaired by RodGravellet-Blondin, General Manager at the JSE, who facilitat-ed, with his accomplished and entertaining skill, two round-table discussions and a presentation.

Roundtable I: Basis for long-term success I – getting right technology and co-operationsOutlining the relevance of Patsystems with respect to emergingmarkets, Kevin Ashby suggested that it was important for theoperators of smaller exchanges to first focus on distribution.Once a consensus had been reached there, exchanges couldthen “work backwards” and source the technology required todo the job.

Echoing Kevin’s point concerning distribution RazvanTudor of the Romanian Commodities Exchange (BRM) sug-gested that if emerging market operators could tap into theenormous take up in newtechnologies in countriessuch as Romania, endeav-ouring to translate this into asimilar take up in trading,then this would almost cer-tainly bring success. Youngpeople would be the tradersand creators of demand forexchange listed products oftomorrow.

Peter Jessup of Computershare Markets Technology identi-fied a trend towards exchange operators and users sourcingstandardised technology solutions from providers. The “shrinkwrapped”, one size fits all solution was still a long way offhowever.

In response to a question by György Dudás of theHungarian clearing house, KELER Ltd, as to what the advan-tages for emerging market operators of engaging (often expen-sive) mainstream technology providers, or of entering into co-operation with developed market operators, were, ArmanFalsafi of the CME pointed out that co-operation should notnecessarily be ruled out on the grounds of cost. From theCME’s perspective there were several different structures andguises that co-operation could take.

Dr Jörg Franke member of the supervisory board of the RTSReal Time Systems Group summed up the discussion by point-ing out that there were up sides and down sides for emergingmarket operators of co-operating with established exchanges.It was true that flexible trading systems could be sourced verycost effectively from technology providers. But co-operation

with established exchanges bought with it know how and expe-rience of the do’s and don’ts of the exchange business.

Presentation of the ‘New Commodity Survey’ by Lamon Rutten, United Nations Conference on Trade and DevelopmentIn an informative overview of global commodities marketsLamon Rutten identified the most significant growth as beinglocated in China and India presently. Attention was drawn todevelopments in India where commodities exchanges hadproved to be leading lights in technological innovation. Thishad facilitated the tremendous growth in trading that had beenfuelled by commodities futures being fully legalised by theIndian Government in 2003.

Speaking from personal experience through building arecent co-operation project between the European EnergyExchange (EEX) and his organisation, Dr Jonathan Butler ofDeutsche Börse Systems affirmed Lamon’s point that it was

often emerging markets thatled the way in innovation. Itwas assumed that emergingmarket operators had a lot tolearn from the experience ofestablished exchange opera-tors and their providers. Itwas important that the con-trary was also fully acknowl-edged.

Roundtable II: Basis for long-term success II – getting liquidity from abroad and at homeCommenting on a question from the moderator, LawrencePeirson of Barclays Capital, about how best to attract liquidityto emerging markets, Otto Nägeli of the Options IndustryCouncil (OIC) explained that it was important to first concen-trate on securing liquidity from domestic market participants.It was they who usually had primary interest in accessing theproducts and market places that were being promoted. Orderflow from international investors would then follow at a laterstage.

Liliana Paraipan of the BRM agreed with Otto’s commentsbut explained that they were working in the environment inRomania where the domestic banks had, until recently, beenprohibited by law from participating in exchange trading.

Simona Simon of Eurex introduced the point that over thecounter (OTC) trading was vibrant and growing in manyemerging markets. The challenge for exchange operators wasto go out to banks and brokers that were conducting businessOTC and to persuade them of the advantages – pooled liquid-

“It is important for theoperators of smallerexchanges to first focus on distribution.”


ity, increased efficiency, better prices and anonymity – of trad-ing on-exchange.

Otto Nägeli added that the mounting expense (particularlywith respect to capital adequacy requirements) and relativeinefficiency of OTC markets was to the increasing competitiveadvantage of organisations setting up on-exchange marketoperations.

On the subject of education Paul Meier, chairman of theSFOA, stressed the importance of keeping politicians withinthe scope of initiatives. Where legislative reforms or modifica-tions were necessary, it was futile to attempt to achieve thesewithout the understanding and co-operation of the legislators.

Urs Rutschmann of Actant AG stated that he thought secur-ing the buy-in of market makers who were willing to under-write certain minimum levels of liquidity in markets was animportant pre-requisite for success in emerging markets. OttoNägeli related this to personal experience from the early daysof the Swiss Options and Financial Futures Exchange (SOF-FEX) where the critical mass of liquidity that had been provid-ed by market makers had often proved to be key.

Shri Sundareshan of the Forward Markets Commission,Government of India, explained exciting developments wherecutting edge technology was being used to pipe market datadirectly from commodities exchanges to screens in local townsacross India.

Shri’s description of the multi-tier nature of commoditiestrading in India (where national and regional exchanges co-existed) prompted the question, what was better for liquidity:several, smaller order books or one centralised market place?The example of the US options market (where the fact that acommon clearing house, the OCC, lay behind all exchangesmade it possible to close out a position at the Pacific Exchange,PCX, that had been originally opened at the Philadelphia StockExchange, PHLX, for example) was cited.

But talking from experience on the exchange users’ side inhis role at UBS, Paul Meier asked if the construction in the USoptions market was really optimal. Paul explained that it wasoften necessary for brokers to seek out the best prices for cus-tomers across the various exchanges, this not always being themost efficient exercise.

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Dr Jonathan Butler, Project Manager, Deutsche Börse Systems AG Contact: [email protected]

Simona Simon, Derivatives Market Business Development – Sales, Eurex Frankfurt AGContact: [email protected]


The necessary evil

Interview with Dr Sharon Brown-Hruska, Commissioner, U.S. Commodity Futures Trading Commission

Bürgenstock, September 9, 2005

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Swiss Derivatives Review (SDR): Dr Brown-Hruska, why didyou come to the Bürgenstock Conference?Dr Sharon Brown-Hruska (SBH): I have always viewed thisconference as a significant international event for the deriva-tives industry. It presents an opportunity for international reg-ulators and participants of the derivatives industry to cometogether to share issues, problems, suggestions, and solutionsin an effort to build a stronger and healthier marketplace.

SDR: And have your expectations been fulfilled so far?SBH: We entertain a very lively and open dialogue here. I thinkall parties profit a lot from it. Especially in the field of mutualrecognition it is beneficial to conduct an intense and ongoingdiscussion, since the markets develop very fast, domestic andcross border.

SDR: What are your goals for your meetings at Bürgenstock?SBH: Derivatives markets are risk shifting markets that aredesigned to help firms andindividuals manage risk. Butwe all know that risk entailsthere will be winners and los-ers. The challenge for regula-tors in derivatives marketshas primarily been to ensurethat the markets represent a“fair game”.

SDR: Does this answer insinuate that the foreign regulatoryprograms are not sufficient?SBH: Not at all, the fact of the matter is that different jurisdic-tions have developed different ways of supervising and moni-toring their markets. That is not to say that one jurisdiction hasa better model of regulation than another – it may simply meanthat it is different. To give you an example, while the CFTCrelies heavily on large trader surveillance of its markets toguard against manipulation, certain European jurisdictions relymore on position limits and what we at the CFTC call “tradepractice surveillance” to monitor markets.

SDR: But you have preferences?SBH: Each of these approaches has its strengths and weak-nesses. While the large trader surveillance approach places aheavy reporting burden on market participants, particularlythe clearing firms who in the U.S. do the reporting, the use ofposition limits can negatively impact market liquidity, con-strain trading and hedging strategies, and impede convergence.

SDR: Currently the area of clearing is higher on the agendas on both sides of the Atlantic?SBH: In Europe brokers operate under universal bankingrequirements, whereas in the U.S., we have specific capitalrequirements and other regulations that govern brokers. Rulesdiffer in the U.S. and Europe on who holds customer funds andhow they are held. Clearinghouses in Europe do not hold cus-tomer funds, whereas in the U.S., the clearinghouse holds suchfunds in segregated accounts. And certainly, the differences inthe bankruptcy treatment of customers in Europe versus theU.S. are both complex and weighty.

SDR: We learned the Eurex is still waiting for approval ofPhase II of the clearing link. Why not a general mutual recog-nition of the respective regulatory programs?SBH: The idea to come to an accord of general mutual recog-nition was not pursued for various reasons.

SDR: Can you specify these alittle bit?SBH: Regulators on bothsides of the Atlantic knowquite well that there are lim-its to mutual recognition ofcomparable regulatory pro-grams. In Phase II of theclearing link, the CFTC hasbeen willing to relax some

requirements for foreign entities when they are clearing U.S.traded products for their European customers. But the chal-lenges become more difficult when it comes to the mechanismsused to clear for U.S. customers.

SDR: Where are the problems located in particular?SBH: One major concern is that this could be at a disadvantagefor domestic suppliers since they would be subject to U.S. reg-ulatory requirements while foreign entities are not. Again,recall that I said that we look to have a fair game and we mustbe sensitive to tipping of the balance, we also must recognizethat clinging to our regulatory model can create barriers tocompetition. I think it is understandable that CFTC cannotaccept a general recognition of a foreign regulator like BaFin,if it would mean that we rely exclusively on the foreign regula-tor to protect US investors. Ensuring the financial integrity ofUS markets is our responsibility, and while we work with otherregulatory authorities, it remains our primary responsibility.

SDR: What solution do you have in mind? I assume the bestsolution may not necessarily be the easiest solution?

“The challenge is to ensurethat the markets representa ‘fair game’.”


SBH: The application of the Clearing Corporation and EurexUS to permit expansion of their Global Clearing Link is not thefirst cross-border or inter-market clearing arrangement theCommission has considered, of course. There have been manybefore and the markets have benefited tremendously.Internationally, the Commission has approved a number ofclearing arrangements, including CME-Simex, CBT-Liffe, andCME-Meff. Each of the clearing links approved by the CFTCwas structured differently to suit the business needs of theexchanges, clearinghouses, and market participants involvedand the markets in which they operate. At this stage I will notspeculate about the outcome of this application, but I am con-fident the solution will benefit all.

SDR: How do you drive the process?SBH: The core question is: What requirements are necessary toensure protection of our domestic customer from unscrupulousbrokers in foreign jurisdictions? Our approach to these issuesis to reach out to our regulatory counterparts and try to findareas where we can rely upon each other to share supervisoryresponsibilities. By the way, this includes swaps of staffbetween the regulators. The concept of mutual recognition ofmarket regulatory regimes isnot a new one for the CFTC.In practice, we must reach alevel of confidence so that wecan determine at any timewhat is happening on themarkets. This may requireadditional reporting by themarket in question. And we must be sure to share all necessaryinformation in conspicuous situations and to jointly investi-gate.

SDR: Wouldn’t it be better to approach these issues on a moregeneral level?SBH: This is the rationale of the transatlantic dialogue to max-imize synergies, which started this spring. CFTC entered into a dialogue with the Committee of European SecuritiesRegulators (CESR) and industry participants to help learn fromeach other how we could encourage competition while retain-ing the integrity of our respective market places. To be moreprecise, we sought a dialogue with CESR on operational andtechnical issues that could impede expansion of cross-borderbusinesses or prevent comprehensive market oversight.

SDR: Any tangible results to date?SBH: We work according to a clear schedule that has threecomponents: first, enhancing transparency and the clarity of

regulatory requirements so that market professionals and end-users located outside a national jurisdiction understand thetypes of conduct that may require registration, licensing orauthorization; second, simplifying access and recognitionprocedures, which may involve the development of practicalarrangements for substituted compliance or recognition-likeprocedures to address access requirements for EU and U.S.financial institutions, and third, targeted consultation on cross-border issues as narrow as the protection of customer fundsand as broad as overall market responsibilities in such areas asproprietary trading.

SDR: And, are you on track so far?SBH: Yes, we had a very fruitful EU-US summit in Washingtonthis summer. I am greatly encouraged by the current spirit ofcooperation and mutual recognition among jurisdictions andhope that reciprocity and respect will carry it further.

SDR: But all this looks very reactive to an outside spectator.SBH: Exchanges drive the business and regulators are thenecessary evil. Necessary, since they contribute substantially to the reputational capital of each market. My hope is that

when derivative productscross jurisdictional bound-aries, regulators can coordi-nate their efforts to assurethat the markets remain openand accessible. The regulato-ry programs need to be trans-parent and almost impercep-

tible, in the sense that they should not be duplicative acrossjurisdictions, nor so different as to create unnecessary costs tomarket operation.

SDR: This sounds plausible in theory.SBH: But, only if we continue to pursue these goals, the mar-kets will continue to grow and flourish to the benefit of marketusers and the economies at large.

SDR: Dr Brown-Hruska, thank you very much for this interview.

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“Our approach includesswaps of staff between the regulators.”

Profile

Dr Sharon Brown-Hruska is Commissioner of the Commodity

Futures Trading Commission and served as its Acting

Chairman in 2004 and 2005. Dr Brown-Hruska has authored

numerous scholary and applied papers in the areas of deriva-

tives and market microstructure. She was awarded the Key

Women in Energy’s Global Leadership Award in 2004.


Globalisation and the proliferation oftrading platforms have accelerated andwidened the demand for more efficientand more open cross-border access ofand to customers, intermediaries andmarkets. At the same time, the ability oftechnology to cross national boundarieshas set a major regulatory challenge forfinancial service regulatory authorities.The response has seen the emergence ofhigh-level inter-jurisdictionalstandards and principlesthrough organisations suchas IOSCO and the BaselCommittee for BankingSupervision and agreementson frameworks of mutualmultilateral, bilateral or evenunilateral regulatory recogni-tion where the rules of a par-ticular jurisdiction, althoughdifferent, are recognised ashaving an outcome that is equivalent to those of the recognising jurisdiction.However, harmonised high-level standards and principles do notresult in rules’ coherence “on theground” and the process of rules’ devel-opment itself has often involved little orno advanced communication betweenEU and US regulators, with the resultthat, even though they may be driven bycomparable public concerns, the conse-quential rules and their outcomes oftenvary significantly from jurisdiction tojurisdiction. Moreover, some, but not all,regulatory authorities are reluctant toengage in mutual recognition where therules of different jurisdictions are notsufficiently converged to their own rule,often reflecting a regulatory policy that isfounded on the principle of “my rule,right or wrong”.

This lack of regulatory cooperationhas generated unnecessary regulatoryduplication and conflict and obstructedthe ability of firms engaged in cost-effec-tive cross-border business and to deliver

the kind of open access, tradingeconomies and commercial efficienciesthat are demanded by their customers.As it was put by Charlie McCreevy, theEuropean Commissioner for InternalMarkets and Services “International co-operation in a globalised world isimperative if we are to create level play-ing fields; if we are to avoid unnecessary,burdensome and costly duplication, and

if we are to deliver higher and consistentstandards that build confidence in capitalmarkets … co-operation between legis-lators and supervisors urgently needs tocatch up with the markets in the waythey work together on a global scale …we must therefore work together to min-imise unnecessary regulatory duplicationand legal friction. This is particularlyimportant in Transatlantic relations. Weare still each other’s most importanttrading partner.”1

It is this interdependence between theEU and the US – evidenced by the sheervolume of financial services traffic (egnearly 60% of US corporate assetsabroad are located in the EU and Europeprovides 75% of all foreign investmentstock in the US) – which is generatinggrowing demand for greater coherence inregulation, simpler rules and improvedtrading and commercial efficiencies. Inresponse to this demand, a group of

Transatlantic financial industry associa-tions2 (now known as the EU-USCoalition on Financial Regulation),working in association with the interna-tional law firm, Clifford Chance, joinedtogether to put forward a consensualTransatlantic “business case” for priorityregulatory action to deliver on theseobjectives and spur the establishment ofa much more efficient and coherently

regulated Transatlantic mar-ketplace.

The Coalition publishedits conclusions in a 200 pagereport “The TransatlanticDialogue in Financial Ser-vices; The Case for Regu-latory Simplification andTrading Efficiency” issued intwo volumes.3 Volume 1 setout the priority areas for reg-ulatory action (summarisedin the next paragraph) andVolume 2, compiled by theinternational law firmClifford Chance, provided

the supporting comparative legal analy-sis of the licensing and business conductrules of the US (in essence the SEC andthe CFTC) and the EU, including notonly relevant directives and implement-ing CESR standards, but the relevantrules of a group of specimen memberstates, namely, France, Germany, Spainand the UK.

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EU/US dialogue in financial services:time to make a start!

“A better framework ofTransatlantic regulation isundoubtedly a ‘win/win’for firms, counterparties,customers and regulatoryauthorities.”

1 Speech by Charlie McCreevy, EuropeanCommissioner for Internal Markets and Servicesmade at a Euro Conference in New York on 20April 2005.

2 ABA Securities Association (ABASA), theBankers Association for Finance and Trade (BAFT),the British Bankers Association (BBA), the FuturesIndustry Association (FIA), the Futures and OptionsAssociation (FOA) and the Securities IndustryAssociation (SIA).

3 Copies of this Report are posted on the websitesof all the Participating Associations currently in theCoalition. A limited number of hard copies can beobtained from the Coalition Secretariat which iscurrently with the FOA (please contact Sally Hugheson T. 44 207 929 0091 / email [email protected]).


The actions identified in Volume 1 ofthe report are not prioritised in terms oftheir deliverability ie whether they can beachieved in the short, medium or longterm or even at all, but they represent theviews of a wide range of organisationsand institutions carrying on cross-borderbusiness between the US and the EU. Theactions include the formulation of a com-mon set of customer definitions for thepurposes of classification,solicitation and documenta-tion; a common approach tocore investor protectionobjectives such as “knowyour customer”; the devel-opment of a common set ofexamination and registrationrequirements; a consensual regulatoryapproach to other firms’ outsourcingarrangements; and the development of aforward programme to simplify criticalareas of regulation such as the obligationto deliver best execution, trade allocationprocedures, distribution of research, etc.The report also urges that the process ofrules’ development should be under-pinned by an agreed set of consensualUS/EU principles of good regulation anda common approach to regulatoryimpact assessments.

The publication of this report hasproved to be particularly timely, bearingin mind:• the increased priority that has been

given by governments in both the USand the EU to taking forward a mean-ingful Transatlantic dialogue in finan-cial services and the dialogue currentlytaking place between various financialservice committees of the Europeanand US parliaments;

• the Financial Markets Regulatory Dia-logue (FMRD) established between theEU Commission and the US Treasury;

• the EU Commission’s own post-FSAPobjective to develop an external regu-latory dimension with third countries,particularly the US;

• the recent arrangements that havebeen entered into by CESR, the SECand the CFTC to develop a frame-work of closer negotiation and co-ordination in the future developmentof their rules. Notwithstanding these various wel-

come developments, the actual deliveryof greater convergence between US andEU rules will nevertheless require a sig-

nificant degree of cross-border consen-sus-building, and a willingness by regula-tory authorities on both sides of theAtlantic to “give and take” on the detailof their rules, to discard prioritising“ownership” of their own rules and topursue a “better regulation” agenda i.e.to focus on delivering what is best, ratherthan hanging onto what is mine!

Despite the considerable degree ofwork and extensive negotiationsinvolved, the establishment of a moresimplified and coherent framework ofregulation of Transatlantic business isundoubtedly a “win/win” for firms,counterparties, customers and regulatoryauthorities. It will improve market par-ticipation and liquidity, enhance firms’commercial efficiency, deliver betterinter-regulatory understanding, simplifythe internal compliance standards offirms and help to contain trading andinvestment cost.

In the round, the objectives that standbehind a meaningful Transatlantic dia-logue in financial services are no dif-ferent to those that stood behind the EU’s Financial Services Action Plan i.e.they are not just regulatory, but also eco-nomic and social – and that necessi-tates engaging all “stakeholders” in the

dialogue – including firms and their cus-tomers as well as regulatory authorities –to ensure that the outcome delivers on allthese objectives in a proportionate andbalanced way. This, in turn, means thatthe dialogue needs to be taken forwardon a genuinely consensual basis in whichall those “stakeholders” are not just thesubject of distant consultation – howevervaluable that may be – but become an

integrated part of the negoti-ating process with their viewsbeing given full and properconsideration. As it is puttowards the end of theForeword to the Report “todo anything less would be toachieve less”.

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“To do less, will be to achieve less.”

Anthony Belchambers, ChiefExecutive Officer of the Futuresand Options Association (FOA),which is an EU industry associa-tion representing 150 banks, bro-kerage houses, commodity dealers,exchanges and lawyers as well asproviders of support services to theindustry.

www.foa.co.uk


Europe – the Financial ServicesAction PlanWe are nearing the end of a long andarduous road. The Financial ServicesAction Plan is almost history. Those 42 legislative, regulatory and advisorymeasures are largely in place at theprimary legislation level. By generalagreement it is a remarkable achieve-ment. Implementing the FSAP measuresin the national laws of 25 member stateswould have been a major undertakingwhatever their content. But in order toreach political agreement on many ofthese measures the level of detail which has had to be incorporated is stagger-ing. The Markets inFinancial Instruments Direc-tive (MiFID) is the mostextreme example.

The current InvestmentServices Directive contains14,381 words. MiFID con-tains 31,451 words. Yet thisis supposed to be a frame-work Directive. And in onesense it is. Despite its inordi-nate length it is only the first stage, theLevel 1 Directive. Over the spring andsummer we have been responding to theCommission’s informal consultation onthe more than 20 areas where theDirective requires the Commission toflesh out the detail in the level 2 imple-menting measures.

There are few people bold enough toguess what the final word count will be.

A vast amount of work remains to be done; by the Commission, ESC (theEuropean Securities Committee), CESR(the Committee of European SecuritiesRegulators), national regulators and byno means least, the investment firms andothers who have to build the IT systems,issue new documentation to clients, trainstaff etc. The timetable for implementa-tion of MiFID remains entirely unrealis-tic, even if the extension until 2007 is

agreed. And some regulators still believethat the industry is exaggerating the scaleof the problem.

The true impact of all this, not leaston 2006/2007 budgets is beginning toimpinge on IT and compliance staff ininvestment firms across Europe.

Winners and LosersIt is worth recalling that the FSAP wasenergised by the March 2000 Lisbonsummit. A key element of the ambitionsexpressed there was to develop a SingleMarket in financial services which would

reduce the cost of capital and improve itsallocation, remove outstanding obstaclesto investment firms offering services andproducts on a cross-border basis in theEU, and give retail investors and saversaccess to a wider range of more com-petitively priced financial products andservices.

There is much that remains to beresolved, some situations could go eitherway, depending to a large degree on thefinal form of the pan-EU regulations, andperhaps more importantly, how those areimplemented (or not) in each MemberState.

Consultants and software providers Over the next two or three years onegroup of undoubted winners will be con-sultants and software providers. Alreadysome are busy whipping up panic

among potential clients with the phrase: ‘MiFID will be worse than Y2K andEuroconversion rolled into one’. Whilst Iwould not wish to underestimate thecosts and problems, there is a certainlevel of cynicism here – it certainly helpsto sell expensive advice and systemsupgrades.

Compliance officers For the last decade, in some jurisdictions,compliance has been a growth market.Now it is set to expand dramatically.Look at the on-going debate in CESR and

the Commission about thepractical means of securingthe independence of thecompliance function. What-ever the outcome, more jobsin compliance are guaranteed.

Global investment banksHere is where the law of unintended consequencesstarts to apply. So much ofthe pressure for page afterpage of detailed regulationscomes from a desire to pre-

serve the market share of local invest-ment firms serving local investors. Butproportionately, it is only the very largestbanks and investment banks that havesufficient resources to absorb the vastlyincreased level of regulatory overheadwhich is about to be imposed upon theEU’s capital markets without significant-ly impairing their profitability. That real-isation is slowly beginning to dawn onthose banks and brokers which have sup-ported their governments in pushing forhighly detailed regulations. They haveleft it dangerously late to exert any influ-ence however.

Hedge fund managersYou may be a little surprised about theinclusion of hedge fund managers on mylist of undoubted winners. But it arisesfrom two factors.

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EU financial markets regulation – winners and losers

“The true impact of MiFIDon IT and compliancebudgets is beginning toimpinge on investmentfirms across Europe.”


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The first is UCITS III which opens thedoor to the promotion of funds whichare, to all intents and purposes, hedgefunds, to a far wider range of investorsthan before. All on the grounds of offer-ing retail investors a greater range ofinvestment products.

Actually, many traditional hedge fundmanagers (if I can use that word todescribe such a recent phenomenon)seem deeply uneasy about having theirfunds marketed to retail investors, giventhe complexity and wide variability ofoutcomes inherent in many of theirinvestment strategies. But many of themajor UCITS managers and the market-ing firms have no such qualms.

Secondly, the incentive to automatethe order handling and trade executionfunctions provided by the new regula-tions will provide opportunities for theefficient execution of ever more complextrading strategies.

IssuersThe Prospectus Directive should, on bal-ance, be a win, at least for issuers fromthe EU. Its worst effects on non-EUissuers have been ameliorated. But forthem it remains complex, ambiguous andcostly. The Transparency Directive,which must be implemented by the endof 2006 is unsatisfactory in a number ofways. This Directive raises the samequestions of equivalence of third countryaccounting standards as arose in theProspectus Directive in more acute formand provides for limited grandfatheringof the use of third country issuers’national accounting standards. Alreadyseveral exchanges, London, Dublin andLuxemburg, fearful of losing third coun-try listings, are developing listingarrangements to mitigate the risks andSWX is looking to pick up any businessthat migrates from the EU. But the jury isstill out.

For underwriters, implementation insome Member States is causing prob-

lems, particularly over the question ofthe liability of managers for statementsin the prospectus. This is compoundedby the Commission’s current considera-tion of whether to propose a directivewhich would limit auditors’ liability forincorrect financial statements.

Less obvious, but possibly far reach-ing, is going to be the impact on issuersof the regulation of dealer markets. It isclear that the motivation behind much ofthe debate on internalisation arises froma perception among regulators, politi-cians and some academics that dealermarkets are inherently suspect. Someclearly would prefer liquidity to be pro-vided solely by investors themselves as inthe central order books of Europe’sexchanges. They are seeking to makedealing with clients, as opposed tobroking for clients, more difficult, expen-sive and risky.

They may well succeed. But that willnot lead, in my view, to the death of thedealer in the EU’s securities markets. Themajor players will continue to provideliquidity to their clients off their ownbooks. But they will concentrate thatliquidity on those shares where positiontaking is least risky, where unwinding aposition can be quick and where theopportunities to hedge at low cost aregreatest. Those will generally be theshares of Europe’s largest, most widelyheld companies. Liquidity (and thereforea lower cost of capital) will flow to thosecompanies which are already liquid andaway from those which really needdealer support. Similarly, smaller brokerdealers who, from time to time, facilitateclient orders by putting their capital atrisk may decide that the risk of beingcaught within the definition of ‘systematicinternaliser’, with all the resulting coststhat result, is too high, and withdrawfrom that market. Investors will have lesschoice and competition for order flowwill diminish. The Commission’s latestdraft regulations are a significant im-

provement in this respect, but it remainsto be seen if they will survive the horse-trading between Member States whichwill take place at the end of this year.

Investors All this new regulation is, of course, alsosupposed to benefit investors. On thenegative side the regulations are going toput up costs for providing products andservices; in some areas substantially.That will probably have to be borne byinvestors. Although if the effect is tointensify competition, we could see thosecosts absorbed by the intermediaries –the banks and brokers – so that investorswill get the benefits but not suffer all thecosts. Instead brokers’ margins will besqueezed.

For institutional investors, frankly Isee little change. Most major investmentbanks have for many years serviced theirinstitutional clients on a cross-borderbasis and have developed work-aroundsfor the many outstanding obstacles todoing that business efficiently – and sohave the clients themselves.

For retail, it’s more difficult to judgeat this stage. Costs will be easier to passon to retail investors than to institution-al investors. On the other hand the pres-sures to automate dealing services forretail are likely to see the major banksdevelop new and cheaper ways to servicethem. The main driver for increasedautomation is going to be the need toachieve and demonstrate compliancewith what will be, for many jurisdic-tions, the new and detailed rules on bestexecution and order handling. Theadvantage this provides to the largestintermediaries over smaller competitorsseems likely to result in less rather thanmore choice of supplier for retailinvestors.

In principle the new organisationalrules on the proper management of con-flicts of interest and a clearer separationof the research, sales and trading func-

“More jobs in complianceare guaranteed.”


tions should give retail clients greaterprotection from abusive practices.Similarly, the detailed requirements for‘know your customer’ suitability, appro-priateness and so on will, if properlyimplemented by the firms and effectivelyenforced by the regulators, bring about amarked improvement in quite a numberof jurisdictions where retail has too oftenbeen viewed as cannon-fodder for theinvestment banking and trading func-tions. Or, to put it more discretely, someretail distribution channels will need to be upgraded so that offers accuratelyreflect changing prices in the inter-pro-fessional market.

Electronic tradingThe perception in the market is that the new regulationswill drive the nextwave of automa-tion, particularly inthe trading space. It will become in-creasingly difficultto comply withrules such as bestexecution if humansare involved in theprocess. The needto provide detailedaudit trails of ordersand order handling; to match trades tomarket provided reference data; to exe-cute orders ‘sequentially’ and to be ableto demonstrate all that to a regulator, all push firms down the road to fullautomation. That will not eliminate theneed for salesmen and traders but it willreinforce the trend of recent years offocussing their efforts on very largetrades with eligible counterparties ratherthan with clients. Only those whodemonstrably add value will survive. Ifthis prediction comes true, it has interest-ing implications for Europe’s corporatebond market, which remains almostexclusively a telephone-based market,

with dealers talking to each other direct-ly, or using inter-dealer brokers to inter-mediate their trades. While most of themajor dealers now have fully automatedbilateral systems which service their bro-ker clients in small orders, which theexception of SWX, none of the manyattempts at creating multilateral systemshas yet proved successful.

Clearing and SettlementFinally, a reference to the last major bat-tle over the future structure of Europe’scapital market which has yet to befought to its conclusion – clearing andsettlement.

The intensity of the debate betweenthose who make a living – and a verycomfortable one thank you – providing

services, has tendedto drown out thevoices of the usersof clearing andsettlement and cus-tody services. It has obscured theprime motivationfor starting thedebate in the firstplace – to secure asignificant reduc-tion in the cost ofcross-border clear-

ing and settlement of equity securities.To do that, there have to be losers amongthe service and infrastructure providers.And if the figures for the costs that couldbe squeezed out of the process are ashigh as some estimates suggest, thoselosses will be substantial – at least on aper trade basis. Fees will come down.Some forms of intermediation will nolonger be needed. Though if lower costsattract additional cross border orderflow, which is what economic theory pre-dicts, those service providers, be theyCSDs, ICSDs or pure custodian banks,which can adapt to a more harshly com-petitive environment, will benefit.

“The need toprovide audittrails will pushfirms down the route toautomation.”

Richard BrittonConsultant on InternationalRegulatory Matters, International Capital MarketAssociation (ICMA)

The International Capital MarketAssociation is the self-regulatoryorganisation and trade associationrepresenting the investment banksand securities firms issuing andtrading in the international capitalmarkets worldwide. ICMA’s mem-bers are located in some 50 coun-tries across the globe, including allthe world’s main financial centres,and currently number some 430firms in total. ICMA performs acrucial central role in the marketby providing and enforcing a self-regulatory code of industry-drivenrules and recommendations whichregulate issuance, trading and settle-ment in international fixed incomeand related instruments. ICMAliaises closely with regulatory andgovernmental authorities, both atthe national and supranationallevel, to ensure that financial regu-lation promotes the efficiency andcost effectiveness of the capitalmarkets.

www.icma-group.org

“Offers to retail will need tobetter reflect prices in theinter-professional market.”

45

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As easy as ABC –Euronext.liffe’s new wholesale services

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The European markets todayEuronext.liffe’s new wholesale equity derivatives initiative isnot only one of the most significant ventures the exchange hasever launched, but also potentially something which will com-pletely reshape the equity derivative landscape.

Many have commented in recent years about a conflictbetween the exchange-traded and over-the-counter (OTC)market places. However, the reality is that these two tradingenvironments frequently overlap and therefore they should notnecessarily be seen as in competition.

Euronext.liffe and many other exchanges have made nosecret of their desire to attract volumes from the OTC environ-ment. After all, any exchange’s business success is very muchbased primarily on how much turnover takes place on its trad-ing platform.

Volume has increased vir-tually continuously on ayear-on-year basis in bothexchange-traded and OTCequity derivatives. However,despite numerous initiatives,such as block trading andFlex options, there has notbeen a significant migrationof business to the exchangesfrom the OTC market. Theexchanges have tried variousways to provide productsthat mimic the OTC market’s conventions, but the evidencesuggests that these have not delivered enough.

Arguments can be made why both markets are ‘better’ thanthe other. Exchanges are more transparent and trading onthem results in significantly lower credit risk than the OTCmarket. But to counter this, the OTC market is more flexiblein terms of option classes available, amounts traded, expira-tion dates and strikes. It is considerably easier to arrangedelta-neutral trades, which is something many alternativeinvestment managers want to do. The reality is that volumegrowth has been greater off- rather than on-exchange. TheOTC market in Europe is now three-times the size of itsexchange ‘rival’.

Recent history has shown that to attract liquidity fromanother market is incredibly difficult. This is true even if theproducts are identical, such as when one exchange lists prod-ucts that are already active on another. The only way liquiditywill shift is if there is an over-whelming value propositionbehind the newer initiative or a huge disparity in the two mar-kets’ technologies. If these conditions are not met, then thestark evidence is that liquidity simply will not move.

The Euronext solutionThe exchange has recognised that many end users will alwaystrade in the OTC market. However, after extensive consulta-tions with equity end users and a thorough analysis of the OTCmarket, Euronext.liffe believes that it can introduce significantefficiencies to it. This is a completely fresh approach, which isvastly different from the traditional one of trying to poachbusiness from the OTC market by introducing look-alike con-tracts or functionality.

What Euronext.liffe is now doing is to combine what manyview as the strongest aspects of the exchange-traded environ-ment with the flexibility of the OTC market. The end resultwill be a far more transparent and efficient OTC market thatwill allow end users to obtain the advantages of trading on an

exchange, while trading inthe manner they, rather thanthe exchange, want.

A 3-component serviceThere are three componentsto Euronext.liffe’s new servic-es. The first, Cscreen, intro-duces efficiency at the frontend, while the other two,Bclear and Afirm, streamlinethe post-trade process.

Cscreen is an establishedpre-trade price discovery

platform that Euronext.liffe bought in April 2005 fromCinnober Financial Technology. There are now 115 differentbroker firms connected to Cscreen, as well as over 200 pricemakers. Even as a stand-alone product, Cscreen introduces realefficiencies to the OTC market. Users can post indications ofinterest (IOIs) on any European, American and Asian singlestocks and indices which removes the need to call around forprices. Cscreen has been designed totally with the way the OTCmarket trades in mind and it has been completely driven by theend users.

At the moment, Cscreen only caters for the vanilla optionmarket, although it provides huge flexibility.

Cscreen can still be used by itself or combined with eitherBclear or Afirm, to provide straight-through-processing (STP)capabilities. This is an incredibly important development forthe OTC equity derivatives market. Few, if any, other systemsprovide the same degree of STP.

Bclear allows OTC trades to be registered, processed andcleared through LCH.Clearnet Ltd. Users can chose betweenstandard and non-standard maturities and strike prices andthey can even design multi-leg structures of combinations of


“OTC market in Europe is now three-times the sizeof its exchange ‘rival’.”

American and European style options, as well as electing foreither cash or physical settlement. This provides many of themost important benefits of trading on exchange to OTC play-ers. Deals can be done anonymously or details can be publishedrapidly to data vendors. Many users will chose to report dealswhen the European Union’s Directive on Markets in FinancialInstruments (MiFID) is implemented sometime in 2007.MiFID’s rules on transparency make it likely that post-tradereporting on the size, time and price of the deal will have to bedone close to real-time. The true STP functionality of Bclearhelps meet these requirements.

Another important aspect is that like exchange-traded trans-actions, all positions are revalued on a daily basis, using fairmarket values. This is something that is meant to be required

already for US-listed corporations under the FAS 133 accountingstandards. It is only a matter of time that European listed com-panies will also have to comply with a similar standard, IAS 39.

Bclear offers huge benefits for both hedge funds and moretraditional asset managers who might find it difficult to accessthe OTC market because of a lack of credit lines. As a result ofusing Bclear, they will now be able to participate as easily in theOTC market as they can trade on an exchange. They will alsobe able to trade out with fresh counterparties. Bclear is a hugeopportunity for the prime brokers to extend their services tostart-up funds with little administrative costs.

Firms wishing to access the system either have to be a mem-ber firm of LIFFE (Euronext.liffe London) or to have a clearingagreement in place with a member firm. Most of these require-

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ments are likely to already be in place for a huge portion of thepotential user base, so the barrier to entry is radically reduced.All funds need is to have a prime broker who a member ofEuronext.liffe.

One of the reasons cited by market practitioners as a causeof the growth of the OTC market is the low cost. Euronext.liffehas addressed this issue with a very straight forward fee struc-ture for Bclear. For instance the service will be charged on a feeper lot basis up to a R 100 cap for house business carried outby exchange members proprietary accounts and R 200 to R 400for their client’s business, regardless of the size of the trades.

The third component of the wholesale initiative is Afirm.This is a matching service for pure OTC trades aimed at theglobal community with ISDAMaster Agreements in placewhich, in its first phase, willcover vanilla single equity andindex options. The launch ofAfirm is very much a stepinto unchartered territory forEuronext.liffe

The exchange believesthat Afirm addresses somevery real concerns about theOTC market and it is fullyinline with ISDA’s strategicvision for automated tradeverification matching and legal execution as outlined in its“Going Forward: A Strategic Plan” paper.

The current OTC post-trade infrastructure is often cumber-some, which raises real concerns about operational risk.Matching and confirming trades is often a slow and expensivemanual task; it is not uncommon for option trades to actuallyexpire before they have even been confirmed. The current sys-tem is totally reliant on counterparties being as efficient as eachother in the back office.

Afirm is an extremely cost effective solution which providesan environment that allows for T+0 trade affirmations andconfirmations. There is no connection cost, no annual chargeand no transaction fees for brokers. The matching or affirma-tion of trades is charged to counterparties; typically, trades willbe charged at a set fee per trade, irrespective of the size of thetransaction. From a technical perspective, because Afirm isaccessible via an FpML Gateway, users can easily connect to itfrom their existing front, middle and back office infrastructure.

Delivering efficiencyIn effect, Euronext.liffe is providing a pick and mix solution for trading, clearing and settling OTC equity options with itsnew initiative. The service is completely agnostic. Even thoughCscreen is designed to seamlessly interface both Bclear andAfirm, end users can chose to use all or just parts of the range.

The initiative really is a radical solution that combines thebest of the OTC and exchange-traded markets. Effectively, abridge has been built between them, further emphasising thatthe markets should not be seen as being constantly in competi-tion. End users can now more easily chose where they want totrade. For instance, a transaction may start its life in the OTCworld on Cscreen, be cleared through Bclear and then

unwound on Euronext.liffeas an exchange-traded con-tract or vice versa. Suchtrades will also potentiallybenefit from cross marginingsynergies.

Taking the three buildingblocks together, A(firm) +B(clear) + C(screen) willresult in a reduction of costs,lower legal, operational andcounterparty risks for OTCequity option players. Euro-next.liffe has provided all

equity option users with real choice about how and where theycarry out their trades and it has established a new paradigm forthe market.

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Fraser Cowie, Executive Directorof Marketing, Euronext.liffe

“The initiative is a radicalsolution that combines the best of the OTC andexchange-traded markets.”

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49Dynamic Growth in Asia PresentsAmple Amount of InvestmentOpportunities As known widely, Asia boasts the highestGDP growth in the world. For example,China, Singapore, India, and Malaysiagrew by 9.5%, 8.4%, 7%,and 6% in 2004 respectively.While high speed of growthwill continue in the Region,slowdown in the US and lowlevel of growth in Europe is expected. Supported bystrong economic growth andstable monetary policies,Asian currencies are expectedto appreciate against majorwestern currencies. Attractedby its high risk premium,large amounts of funds have been flowinginto this Region, besides abundant liquid-ity within the Region itself. This has cer-tainly contributed to the out-performanceby the Asian equities since Jan 2002 overthe aggregate world market (see Chart 1).For example, YTD 2005 (throughSeptember), Korea has been experiencinga strong bull run with 33.18% in return(KOSPI), compared with 4.71% byMSCI World. In Japan, corporate profitshave been improving and economicrecovery is on track, as indicated by thehigh stock market returns recently(TOPIX: 11.09% in September 05). Sincethe 1997 Asian Crisis, companies haveundergone restructuring and have nowmuch more sound balance sheets, sup-porting good returns for credits (JACI:3.81% vs. SSB All CCC Rated: –1.18%YTD 05).

On the other hand, what is going on in Asia is also increasingly affectingglobal economy and financial markets.For example, commodity prices havealso been climbing due to strong demandfrom China. The prospect of RMB reval-uation also contributes to fluctuation ofmajor currencies such the US Dollar andJapanese Yen.

In short, Asia increasingly asserts itsimportance in global economy and finan-cial markets. It offers investors greatinvestment opportunities in terms of highreturn potential and means of diversifi-cation.

Challenges and Potential PitfallsHowever, to generate steady returns withcontrolled volatility is challenging in thisRegion. There are three main reasons.First, Asian markets are inherently high-

ly volatile due to its emerging marketnature (fund flows have huge impact onprice movements). Second, return distri-bution exhibits wide dispersion bothacross difference countries and time peri-ods. Third, there are local characteristics

that may present potentialpitfalls for investors. Theyinclude cultural barriers suchas language difficulties,investment and sectoralimbalances, disparate growthrates, and information asym-metry / the connection effect.In the Asian credit market,for example, there are manyinvestors such as banks whomake investment decisionsbased on regulatory, cultural

or bureaucratic rather than economicalreasons. Such behaviour of theseinvestors leads to mispricing in assets.Investors who do not understand thespecific dynamics at play and try to

Extract high risk premium in Asiathrough dynamic hedge fund strategies

Since the last couple of years, Asia has attracted significant fund flows thanks to its high economic growth

and well-performing financial markets. However, high risk premium does not mean that high and steady returns

are easy to come by. High volatility and local characteristics present great challenges. Investment directly

through long only instruments could actually cost investors dearly. We believe that dynamic hedge fund strate-

gies in a fund of funds structure are the best way to extract the high risk premium presented by this Region.

“Asia offers investors greatinvestment opportunities in terms of high returnpotential and means of diversification.”

7.0

9.0

1.1

3.1

5.1

7.1

Dec0

1

Feb-

02

Apr

-02

Jun-

02

Aug-

02

Oct

-02

Dec-

02

Feb-

03

Apr

-03

Jun-

03

Aug-

03

Oct

-03

Dec-

03

Feb-

04

Apr

-04

Jun-

04

Aug-

04

Oct

-04

Dec-

04

Feb-

05

Apr

-05

Jun-

05

Aug-

05

Source: Bloomberg. Through Sept 2005

Chart 1: Asia has outperformed the world equity market since 2002.


apply the usual credit analysis will not beable to identify the arbitrage opportuni-ties in the market. At the same time,investors with strong network within thebusiness community in Asia possess aninformation edge which is particularlyimportant when family controlled busi-nesses are still prevalent in the regionand access to ownership in addition tomanagement is critical for making thecorrect investment decisions. After all,high growth rates do not necessarily gettranslated into high capital gains auto-matically; one needs to haveexperience and local knowl-edge and apply the appropri-ate strategies and techniquesto profit in this region.

Dynamic Hedge FundStrategies Turn Chal-lenges into OpportunitiesDynamic hedge fund strate-gies compare favourablyagainst the traditional longonly approach in tapping into the vastinvestment opportunities in Asia. First ofall, they can mitigate portfolio volatilitythrough active exposure management,whereas long only investments have toride through ups and downs with themarket (see Chart 2). In addition, hedgefunds can turn the regional challengesinto opportunities since they employ abroader array of financial instrumentsand apply a greater variety of strategiesincluding shorting and relative valueplays. They can react to changes in thefinancial markets more nimbly becausethey are free of benchmark constraints,can go either long or short, and canleverage up or go to cash according tomarket conditions. Due to these reasonsas well as their substantial experienceand local knowledge, hedge fund man-agers can exploit market inefficienciesmore effectively than their traditionalcounterparts. Take the Asia ex-JapanFixed Income Market as an example.

Hedge funds can turn disequilibrium intoopportunities:

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“However, to generatesteady returns withcontrolled volatility is challenging in thisRegion.”

“ylno gnoL„esrevinU

low

<5

%

high

>1

0%

Vol

atili

ty

5–1

0%

Source: Swiss Capital Alternatives Investments

Negative“Short”Beta <0

Market“Neutral”Beta = 0

Positive“Long”Beta >0

Hedge Fund

Traditional Portfolio

Chart 2: Flexibility of hedge fund strategies.

Local Characteristics Arbitrage Strategies • Foreign exchange and capital � • Arbitrage trades between

account restrictions on domestic on-shore and off-shore securities investors

• Varying monetary and fiscal � • Interest rate “carry” and policies across the region convergence trades

• Emphasis on “name” investing � • Inter-company relative value rather than fundamental credit trades/short opportunitiesanalysis


Figure 1 captures the advantages ofdynamic hedge fund strategies. Thanksto their absolute return approach, hedgefunds can protect downside (resultinglow to medium volatility and capitalpreservation due to minimal drawdown)while being able to participate whenmarkets go up (see Chart 3). Therefore,they possess better risk return profile.

The Advantages of Fund of Hedge FundsNotwithstanding all the advantages ofhedge funds, investment directly into sin-gle managers proves difficult for averageinvestors for the following reasons. First,manager skills vary greatly and hencetheir performance. Second, investing insingle managers subjects investors to sin-gle strategy or market risks (see Chart 4).A fund of funds structure reduces singlemanager and strategy risk and can opti-mise risk-adjusted return throughdynamic asset allocation both at thestrategy and single hedge fund level.

An experienced fund of hedge fundsmanager like Swiss Capital AlternativeInvestments offers the following:• Professionals with extensive experi-

ence and expertise in Asia. • Institutional quality investment man-

agement process that provides• Effective and dynamic strategy

allocation. To do this effectivelyrequires extensive knowledge ofthe impact of economic and marketdrivers on expected risk andreturns of various hedge fundstrategies.

• Value-added manager selection. Itinvolves thorough due diligenceand discernment on the manager,his or her trading strategies andoperations.

• Clear portfolio construction con-cept, rigorous risk managementand proven methodologies for

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“We believe that dynamichedge fund strategies in afund of funds structure arethe best way to extract thehigh risk premium presentedby this Region.”

fo scitsiretcarahC lanoitidart soiloftrop

ytilitaloV hgiH )ytilitalov tigid elbuod(

noitautculf nruter hgiHmret gnol revo ylno sseccuS

erusopxE tekraM hgiH )1 ateB(

snrutnwod tekram gnirud ecnarusni oN

fo segatnavdA lanoitidart-non soiloftrop

ytilitaloV etaredoM )ytilitalov tigid elgnis(

snruter ydaetS smret gnol dna muidem ,trohs ni sseccuS

erusopxE tekraM elbixelF )1+ ot 1- ateB(

tekram gnirud tiforp neve dna ecnarusnIsnrutnwod

srevird nruter ksiRstnemtsevni tekram laicnanif fo

stnempoleved cimonoceorcam labolGrotces dna yrtnuoc cificepS

stnempolevedkooltuo htworg cificeps ynapmoC

Source: Swiss Capital Alternative Investments

Figure 1: Advantages of non-traditional strategies over traditional strategies.

%04

%06

%08

%001

%021

%041

%061

-naJ00

-luJ00

-naJ10

-luJ10

-naJ20

-luJ20

-naJ30

-luJ30

-naJ40

-luJ40

-naJ50

-luJ50

Source: EurekaHedge, Bloomberg. Through Sept 2005

Chart 3: Hedge funds protect downside while being able to capture upside.


implementation. Through thought-ful analysis of each underlyingmanager and aggregation of keyrisk exposures to the portfoliolevel, Swiss Capital AlternativeInvestments is able to gain insightinto the positioning of the portfo-lio with regard to market exposure(beta) and volatility as well as therelationship between the main riskfactors and return pattern expecta-tions of the portfolio to ensure riskreturn objectives.

ConclusionIn summary, Asia presents attractive riskpremium but investment directly throughlong only instruments is highly risky dueto its volatile nature and local challengesas an emerging market. We believedynamic hedge fund strategies in a fundof funds structure can help investorsprofit most from investment opportuni-ties therein due to their absolute returnapproach and diversification benefits dis-cussed above.

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240%

210%

180%

150%

120%

90%

60%

30%

50-luJ50-naJ40-luJ40-naJ30-luJ30-naJ20-luJ20-naJ10-luJ10-naJ00-luJ00-naJ

Source: EurekaHedge, Bloomberg. Through Sept 2005

EH Asia incl. Japan EurekaHedge Greater China EurekaHedge Japan

Chart 4: Pronounced volatility and wide dispersion of returns in Asian hedgefund market.

Hans-Jörg Baumann CEO & Chairman Swiss Capital Alternative Investments AG

[email protected]

Xiao ZhangAssociate DirectorInvestment & Portfolio Management Swiss Capital Alternative Investments AG

[email protected]


The insurance industry looked for alter-native risk-financing sources for peakrisks in the mid-1990s after HurricaneAndrew in 1992 caused a number ofreinsurers to go bankrupt. Reinsurancecompanies turned to the capital marketsusing various forms of insurance linkedsecurities. The catastrophe bond market– known as cat bonds – has now unfold-ed and developed to a current volume ofUSD 5.3 bn in issues. (Overall, bonds inexcess of USD 13 bn have been placed sofar). Various investors participate in thisliquid market, such as traditional assetmanagers, hedge funds, cat bond fundsand to some extent insurance companiesthemselves. The basic struc-ture that is currently themost commonly used for theissuance of cat bonds isshown in the first graph(Figure 1).

This figure involves aninsurance or reinsurancecompany incorporating aspecial purpose vehicle(“SPV”). The SPV’s purpose is to transferinsurance risk into the capital marketsthrough the issuance of cat bonds. TheSPV assumes the risk of a type of catas-trophe from the re-/insurance companythrough a retrocession contract. In re-turn, the SPV receives insurance premi-ums from the sponsor. The purchaser of

the bonds receives an annual payment ofLIBOR plus the premium. At maturity(on average 3 to 5 years) the full princi-pal is paid back if no catastrophe such asa hurricane, earthquake or winter stormhas occurred.

In addition to the typical cat bonds,other forms of investments such as deriv-atives are used by portfolio managers.The industry loss warranty is a reinsur-ance product that provides coverageupon the occurrence of catastrophes thatgenerate an industry loss of a pre-definedsize.

The advantages of allocating assets toinsurance linked securities are consider-

able: low to negative correlations to bothtraditional and alternative assets,favourable risk/return features, lowvolatility and no duration risk forstraight cat bonds.

The matrix (Figure 2, p. 53) shows thecorrelations over a five year period. Therisks of this asset class are independent

of financial markets. A hurricane or anearthquake is never the consequence offalling stock markets, nor does a soaringmarket activate a hurricane. On the basisof the capital market theory, an allo-cation to insurance linked securitiesenhances the efficient frontier andimproves diversification. The probabilityof bankruptcy determining the rating ofcorporate bonds is comparable to theprobability of the insured event (mainlynatural catastrophes) occurring. Hencethe pure credit risk of cat bonds can beneglected. The assessment of the expect-ed risk for cat bonds is carried out bythird party scientific modelling firms.

Total costs still notknownHurricane Katrina, an eventoccurring only roughly every50 to 80 years, caused thedams to burst. The subse-quent flood produced furthermassive damages. Thereforebonds covering hurricane

losses were not triggered but only under-went minor mark-to-market adjust-ments. Nevertheless, some ILS portfoliossuffered drawdowns in August and willpotentially show a negative performancein September as well. These losses origi-nate from structures where the trigger fora potential loss is set upon the accumula-tion of damages. For the first time, a catbond defaulted as the cumulated dam-age for the related insurance companyexceeded the defined threshold.However, the financial confirmation bythe insurance company is still to bereleased. Overall estimates of the totalinsured damage amount to USD 34 bn asof today. Investments with a hurdle ratein excess of, for example, USD 20 bn aretriggered and, depending on their struc-ture, are to be written off. Still, it willtake at least another month until fairvaluations of investments related toderivative structures based on the total

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Why insurance linked securities are attractive investments after the hurricane seasonWeekly news about hurricanes striking the Gulf of Mexico and the US coast is not unusual for autumn. We have

all seen the images of the massive floods and damage caused by Hurricane Katrina and Hurricane Rita. Overall,

Insurance Linked Securities portfolios had to mark down or write off investments. Bank Leu provides you with

some information on how you could have avoided large drawdowns and how you can position yourself to bene-

fit from rising insurance premiums.

“The advantage of allocating assets to … no duration risk forstraight cat bonds.”

Insured

Sponsor

SPV*SPV* InvestorInvestor

Premium

Notes purchase agreement

Investment proceeds

USD Par amount

Trust

Account

Trust

Account

Swap agreement

LIBOR

LIBOR

LIBOR + Premium

InsuredSponsor

Reinsurance agreement

SwapcounterpartyMin. Rating

AA-

Figure 1

Source: Bank Leu, Investment Products


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damage in the region around Louisianacan be made. The total impact of hurri-canes Katrina and Rita cannot be meas-ured yet, as there are uncertaintiesregarding firm loss estimates.

What lessons can be learnt for you asan investor and why is an investment inthis asset class even more attractive afterthese major events? “The lessons to belearnt from hurricanes Katrina und Ritaare twofold: first of all know what youbuy and second assess your risk toler-ance.”

Let’s elaborate on these statements asfollows. As previously discussed, the ILSmarket has developed into a source ofalternative assets for professional moneymanagers. This wholesale market hasrecently originated various structurescovering the full range of ILS and deriv-atives. For a long time Bank Leu was oneof the first financial institutions offeringa broadly diversified fund of cat bonds toits investors (private and institutional).

The first fund, launched in 2002, had toclose within 6 months for capacity andyield protection reasons. The subsequentfund, also a cat bond fund, was launchedin 2003 and again capped. These fundsare both registered with the SwissFederal Banking Commission (EBK).Bank Leu is one of the top market play-ers with USD 800 bn of ILS, mainly catbonds, under management. To ourknowledge there is no UCITS (admittedin the EU) cat bond fund or a broaderILS fund in circulation. Many offshorestructures have been set up over the lasttwo years. These offshore structures areinvestment funds, fund-of-funds orhedge funds.

Bank Leu has the expertiseThe nature of these vehicles is normallyrather opaque and does not offer fulltransparency (no full “look through”principle). An ILS fund-of-funds still hasmany good reasons for its specific struc-

ture: in most of the cases the assetmanager is not an insurance expert.Therefore he has limited capabilities and know-how to assess risk. Particularindustry insights, relationships andknowledge are prerequisites to calculateand subsequently manage these insur-ance related risks. For the measurementof insurance risks and impacts on thewhole portfolio, special software isrequired. Bank Leu, for example, hasinvested in both people and software.Two ex-industry specialists run simula-tions, assess risks and manage the port-folio. To model risk a huge data base thatcontains over hundreds of years of eventsis required.

The second point is related to yourrisk tolerance. Obviously no ILS invest-ment can be considered as a short-termtrading opportunity. A pure cat bondfund offers less performance than abroadly diversified ILS fund with morerisks, such as aviation, space or life. On

01.04.2000 –S&P 500 DJ EuroStoxx 50 SMI

31.05.2005

Cat Bond PF 0.09 0.15 0.12

Source: Bank Leu, Investments Products

Cat Bond Portfolio and Stock Markets

01.04.2000 –Citigroup World GBI Citigroup EMU GBI Citigroup Switzerland GBI

31.05.2005

Cat Bond PF –0.01 0.01 0.01

Cat Bond Portfolio and Bond Indices

01.04.2000 –Hennesse HF Fixed Inc. Tremont Fixed Inc. Arb. HFR Relative Arb.

31.05.2005

Cat Bond PF 0.06 0.02 0.11

Cat Bond Portfolio and Hedge Funds Indices

Figure 2


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the other hand, tail risk has improvedthrough diversification, and the recoveryperiod from a drawdown is shorter in adiversified vehicle. We advise you tocarefully conduct due diligence on therisk/reward constellation ofthe single investments andthe whole portfolio. That’swhy the range of perform-ance contribution is wide forAugust 2005. Some cat bondfunds did not incur nominallosses in August and evenshow a slight positive per-formance in the USDtranche. Other offshore vehicles incurredlosses in excess of 10% in August. Thesefunds invest in derivative structures suchas ILWs in addition to cat bonds. Toavoid nasty surprises, you have to be

aware of the trigger mechanics and thestructures of the underlying instruments.

Hurricanes Katrina und Rita havereduced capacity in the insurance indus-try (reinsurance included). Insurers will

have to improve their balance sheets.Because they will have to negotiate newcontracts, insurance companies will haveto increase premiums at renewal date on1 January 2006. The uncertainty regard-

ing final estimates of total losses remainshigh. Once the industry has gained aclearer picture of the final impacts ofthese hurricanes on ILS portfolios, youcan compare the performance of various

funds for August, Septemberand October. We believe thatthe ILS market is very attrac-tive and advise investors toposition themselves to benefitfrom the premium increasesthat will start in January2006.

Silvia Graemiger Theler, Vice-President, Bank Leu, is developing key relationships for Bank Leu’sinvestment product department since March 2005. Previously, she had positions at Partners Group,CSFB and UBS and holds a degree from the University of St. Gallen.

Contact: [email protected]


“The lessons to be learntfrom hurricanes … assessyour risk tolerance.”

What is happening in South America?

Soybean production is growing significantly year after year

and just one Exchange can show for the other two:

The Mercado a Termino de Buenos Aires – MATba.

58

Pro

file

South America presents itself as the future world leader in soy-bean, meal and oil production of the world. With almost halfthe beans in the world between Argentina and Brazil, the mostimportant participants in the Soy business are turning towardsArgentina to increase their crushing capacities. In this, the totalcrushing figures will go from what is being currently crushedaround 100,174 metric tons a day to 164,714 metric tons in2006, placing Argentina as the most important crusher, slight-ly over the United States of America by 2.5%.

It is not unusual that Argentina has been chosen to be center stage in this development. Since 1907, year in which the Mercado a Término deBuenos Aires was founded,Argentina has been pioneerin the agricultural futuresindustry south from Mexico.During the first half of the twentieth century, theMATba has traded differentagricultural commodities.Among them, Flaxseed, which made the MATba the bench-mark market in the world for this product until the end ofWWII.

With a clear aim to ensure transparency in the grain market.The MATba was the first exchange in America to guaranteeevery single trade that was registered by its members.Nowadays, its management and the Board of Directors stillbelieve in those core values defined in 1907 by its founders.Values such as to ensure transparency, keep the highest qualityin service and to promote creative professional environmentare one of the constants of a successful history, now close to itsfirst hundredth anniversary.

In the 1990s, MATba started trading options, thus becom-ing a complete hedge offer exchange for the agricultural indus-try in Argentina. Also, during this decade, the exchange was

authorized by the government to carry out its trade in USDollars. This provided a solid base to the trade, especiallywhen Argentina was going through an inflationary crisis.Trading in Dollars proved to be a successful once again duringthe last crisis in Argentina, between 2001 and 2002.

After Argentina defaulted, all exchanges in the country wereforced to suspend their trading temporarily. This meant forMATba to reimburse all its members and to bring its openinterest to zero.

Nowadays, MATba is growing at an astonishing high speed,trading more than two thirds of the volume that was traded

before the 2002 crisis (seechart).

The future looks bright forArgentina and for MATba aswell, as it becomes more andmore involved in creatinginternational partnershipsand agreements with themost representative exchanges

in the world. Such is the case of the Memorandum ofUnderstanding signed last May, 2005 with the Chicago Boardof Trade in the spirit of joint developing the second part of theSouth American Soybean Futures Contract. In this stage, a SoyMeal contract will be added to the Soybean offer and the pos-sibility to trade directly in the Argentinean port of Rosario, aport that has been in demand for some time now, especiallyfrom European countries.

The Mercado a Término de Buenos Aires has a lot to offerto the local and international community and it will be knownin the future to be the reference market for the Argentineangrain industry, for MATba also trades Wheat, Corn andSunflower Seed.

The Buenos Aires Futures and Options Exchange welcomesinquiries and chances to reciprocate with other participants ofthe industry. Further information could be found in our web-site: www.matba.com.ar

“The MATba was the firstexchange in America to guar-antee every single trade.”

Volume From 1995 to 2005

0

5.000.000

10.000.000

15.000.000

20.000.000

25.000.000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005*

Year

M

etric

Tons

* To September 13th, 2005

Gustavo Picolla is the President andCEO of the Buenos Aires Futuresand Options Exchange (Mercado aTérmino de Buenos Aires) whichwas established in 1907 to be thepioneer exchange in South America.

www.matba.com.ar


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