December 8, 2003	Monday	Shawwal 13, 1424

One of the most dramatic changes in the world of finance during the past 15 years has been the extraordinary development of the markets for derivatives. Derivatives have transformed the world of finance, increasing the range of financial products available to corporations and investors and fostering more precise ways of understanding, quantifying, and managing risk. These important markets are large and growing rapidly.

The trend towards deregulation of financial markets, following the current emphasis on privatization in Pakistan, has created new investment opportunities, which in turn require the development of new instruments to deal with the increased risks. Stakeholders are exposed to stock price, commodity and interest rate volatility and require appropriate hedging products to deal with them.

The current economic expansion in Pakistan demands that corporations find better ways to manage financial and commodity risks. The instruments that allow market participants to manage risk are known as derivatives because they represent contracts whose pay-off at expiration is determined by the price of the underlying asset—a currency, an interest rate, a commodity, or a stock.

Derivative contracts are traded or entered into in several trading environments. Derivatives traded on an exchange are called exchange-traded derivatives. The primary purpose of exchanges is to aggregate a large number of participants in order to build liquidity in a contract. Contracts entered into through private negotiation are typically called off-exchange or OTC (over the counter) derivatives.

Participants: Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.

Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

The price of risk is determined by the interaction between how much hedgers are willing to pay to reduce risk and how much speculators require to bear it. Arbitrageurs ensure that the prices of individual risk-bearing instruments are consistent across the various derivative contracts. A well-functioning derivative market requires all three kinds of traders.

Exchange-traded: The OTC ( over-the-counter) markets have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and located within individual institutions.

2. There are no formal centralized limits on individual positions, leverage, or margining.

3. There are no formal rules for risk and burden-sharing.

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Interest rate derivatives: Trading in interest rate derivatives market enhances liquidity of the interest rate spot market through three channels:

1. Arbitrage between spot and derivative market generates a new order flow for the spot market.

2. Access to derivatives, which can be used in hedging systematic risk factors, reduces the economic cost of holding undiversified inventories in spot market trading and hence improves the supply of liquidity on the spot market.

3. Access to leveraged speculation on interest rates on the interest rate derivative markets increases the supply of research and forecasting about interest rates. This reduces uncertainty about future interest rates, and helps to narrows spreads on the spot market.

Rationale: “ Substantial exposure to interest rate risk of economic agents in Pakistan. Interest rate derivatives reduce the stakeholders’ vulnerability to interest rate volatility

“Substantial exposure to foreign exchange risk of multinationals in Pakistan. Exchange rate derivatives reduce the stakeholders’ vulnerability to exchange rate volatility

“The role derivatives can play in opening up access to the market to all economic agents, and obtaining liquidity and market efficiency.

There have been some positive developments in Pakistan on this front. In March 2003, a seminar was organized by the Pakistan Banking Association on “Derivatives - The Way Forward”, and was spearheaded by three leading banks, the ABN-AMRO, Citibank and the Standard Chartered Bank. In the seminar, the Governor of the SBP said that Pakistan was open and receptive to foreign banks, because of their transfer of knowledge, technology and best practices and from learning from the experience of regional and international markets. He also stressed on the importance of proper systems, procedures, expertise and internal controls needed for such an initiative.

There was also a seminar organized by the Habib Bank in September 2003, on the advice of the SBP, introducing a variety of interest rate and foreign exchange derivative instruments and products.

Initiatives: The primary function of derivatives exchange is to facilitate the transfer of risk among economic agents by offering mechanisms for liquidity and price discovery, enhancing public information, and lowering transaction costs, but the success of a derivatives exchange depends on the soundness of the foundations on which it is built, the structure that is adopted, and the products that are traded.

Market features: (Standardization) Standardization ensures that any one contract is indistinguishable from any other in terms of what, how much, when, and where an underlying is to be delivered.

Trading platform: The trading platform is the mechanism by which buyers and sellers are brought together and orders are matched. Traditionally, it has been an open outcry system on a designated trading floor at an exchange, but during the past decade, there has been a move to establish electronic markets for trading in derivative contracts.

Clearing system: Clearing is the procedure by which the clearinghouse becomes the buyer to each seller and the seller to each buyer of every futures and options contract traded on the exchange.

The mechanics of clearing a trade are straightforward. Once a trade has occurred on the exchange floor or electronic trading system, the information from the trades is sent to the clearinghouse for confirmation. The clearinghouse checks that the information provided by the two parties matches exactly. If it does, the clearinghouse takes the opposite side of each counterparty that entered into the trade on the exchange, hence allowing contracts to be fungible and making it easy for parties to enter into and exit contracts.

In the process of making contracts fungible, clearinghouses assure the financial integrity of the contracts. That is, the clearinghouse establishes a guarantee of performance on the contracts. This is typically accomplished through five levels of control that come into play before transactions are ever entered into, while contracts are being held and after problems may arise:

* The first level, control of the credit risk faced by the clearinghouse, is accomplished by admitting only creditworthy counterparties to membership in the clearinghouse. Most clearinghouses do this by establishing minimum financial requirements and standards that its members must meet on an ongoing basis.

* As a second level of control, clearinghouses may impose position limits on members or its members’ customers to limit the potential losses to which a member may be exposed.

* The third level of control is to establish a “margining system” to cover the risk of positions that have been entered into. A margin is essentially a performance bond designed to cover potential short-term losses on futures and options positions.

* The fourth means of protecting contracts is to establish default procedures in the event that a clearing member does default.

* The fifth level of protection is to establish supplemental resources to cover situations in which a margin is insufficient to cover losses. This may take the form of outside guarantees, insurance, excess reserve funds, or collateral pools.

Over-the-counter markets: Over-the-counter is commonly used simply to describe trading activity that does not take place on an exchange, whether that exchange is a futures, options, or stock exchange. OTC derivatives are described as contracts that are entered into between counterparties, also called principals, outside centralized trading facilities. In OTC markets, counterparties typically negotiate contract terms such as the price, maturity, and size of the contract in order to customize the contract to meet their economic needs. Moreover, because OTC contracts are entered into on a principal-to-principal basis, each counterparty is exposed to the credit risk of the opposite party.

It is an alternative to exchange traded derivatives for parties interested in entering into derivative contracts. Exchange traded contracts offer high liquidity and low credit risk, but typically they are standardized and inflexible, meaning that users often face large basis risk when using the contracts to hedge. By being able to negotiate contract terms, users can reduce basis risk by assuring that the terms of derivative contracts more closely match the characteristics of their physical market positions; however, the advantage of customization generally comes at the expense of liquidity and credit assurances.

Conclusion: For the establishment of a derivatives exchange, policymakers should begin with a feasibility analysis. Such an analysis should identify key areas of weakness, and formulate plans to address these areas. There is no point in proceeding with the design of the exchange and the products to be traded until such an analysis is conducted.

The next step involves selecting the products to be traded and deciding on the elements of the exchange’s microstructure.

The most important step in accelerating the process is the presence of the necessary human resources with derivatives expertise to spearhead the process. Personnel with such sophistication are limited worldwide and are in high demand, hence expensive. Pakistan needs to immediately import such resources to jump-start the process and make a forceful impact in this arena. This might be expensive at first, but the investment will pay off in the long run and will put Pakistan on the path of becoming a major force in world financial markets.

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