Futures on stocks were introduced at the Karachi Stock Exchange (KSE) in July 2001. The overriding objective behind their introduction was to bring in a missing trading instrument.

In general, Futures offer a number of benefits to investors, which are hedging, price discovery, speculation, leveraged trading, arbitrage, and lower transaction costs. It has been over a year since Futures were introduced at the KSE, and now is the time to look back and see whether or not Futures have been successful.

We shall go about measuring the success of Futures by using a number of criterion, each posed as a question:

1. What is the traded value of Futures and is it growing?

The average traded value of Futures was Rs0.4 billion in September 2001 which increased to Rs1.5 billion in August 2002— a growth of 275 per cent, as shown in Figure 1. The growth in the daily traded value is still continuing, as shown by the 30-day moving average of the Futures.

2. How does the traded value of Futures compare with that in the Ready Market?

The average daily traded value of Futures was as little as 18 per cent of the Ready Market in September-November 2001. It has increased to 42 per cent in June—August 2002, as shown in Figure 2.

At times when activity in Ready Market was very low, traded value of Futures exceeded that of the Ready market. This is particularly interesting because the traded value for Futures is for a maximum of 13 scrips whereas the traded value for Ready market includes all scrips.

3. How does the traded value of Futures at the KSE compare with the traded value at the National Stock Exchange (NSE), in India?

The daily traded value of Futures is 15 per cent of the daily traded value of stock Futures at the NSE as shown in table 1. This is significant because the market capitalization at the KSE is about 5 per cent of the market capitalization at the Bombay Stock Exchange (BSE). Similarly the traded value at the KSE is about 18 per cent of the traded value at the BSE. We have compared the KSE with both the BSE and the NSE because as the KSE accounts for most of the turnover in both Ready and Futures market in Pakistan, the BSE is the largest Ready market and the NSE is the largest Futures market in India.

Note that the comparison is a bit unfair due to two reasons. First Badla was banned in India, which forced the investors into the derivatives, causing the Futures to take off. Second, stock Futures were introduced in India in 2000, i.e. they are older than stock futures in Pakistan.

4. What is the degree of scrip-wise concentration in Futures trading?

Futures market is narrower than both Ready and Badla. This is apparent if you compare the share of average daily traded value of the Hubco, the PTCL, the PSO, and others across the three markets as given in Table 2.

Futures market was unlikely to be wider than Ready but it seems that it is narrower than what one would have expected even after adjusting for the lesser number of scrips in Futures.

5. Have Futures fulfilled market needs?

Probably the most important criteria in determining the success of Futures is to judge whether bringing in this missing instrument has fulfilled market needs. Our opinion in this missing instrument has fulfilled market needs. Our opinion is that so far Futures are being used primarily for speculation and arbitrage. However, we do hope that as the institutional presence increases in the stock market, it is likely that Futures would also be used for the larger economic need of hedging.

6. How does the performance of Future compare with their potential?

Keeping in mind that Future are just a year old, potential over time is bound to be high. Our view is that the potential size of the Futures market is far more than its current size because:

* Futures are subject to tighter regulations.

* There is no index trading.

* There is lack of investor awareness.

Since creating investor awareness is a slow and gradual process, we would focus on regulations and lack of index trading.The following regulations and operational problems are particularly getting in the way of Futures:

i. At least 50 per cent of the margin in Futures is required to be deposited in cash. Unlikely margins in the form of securities — as accepted in the Ready market — cash margins create an opportunity loss for the trader, which increases the transaction costs. Note that internationally Futures offer significantly lower transaction costs compared to the Ready market.

ii. Futures are subject to higher margins. For instance, for an exposure of Rs50 million, the margin required in Ready is 5 per cent, while in Future it is 7.5 per cent. Similarly there are problems in other exposure brackets. iii. Open positions at contract expiry are to be settled by delivery of shares. Internationally, delivery in Futures is rare. Almost 99 per cent of the contracts are offset or squared and the open positions at contract expiry are settled in cash.

In case of a sale position of more than Rs 50 million, the actual shares sold above the limit are to be deposited, or documentary evidence is required that the shares are in the CDC or some bank or DFI. Futures prices are derived from the prices in the Ready market and Arbitrage would ensure that the Futures price does not deviate too far from the price of the underlying security. Since selling in Futures is essentially “Blank”, there should not be any restriction on possession of shares.

v. Current regulations need to be amended to cater for index trading. For instance there is no delivery in Index Futures, there are no direct circuit breakers, etc. Index trading represents a significant share of stock-Futures market internationally and it is essential for hedging for portfolio managers who track the index.

vi. So far there are only 13 scrips and one-month contract. It seems possible to increase the number of scrips in Futures and the types of contracts traded.

Conclusion: While Futures have been reasonably successful at the KSE, their performance is below potential. We used very simple criteria to determine the success of Futures and are of the view that adding additional criteria or further analyzing is neither likely to change nor significantly add to the conclusion that Futures have been reasonably successful at the KSE. As for helping Futures realize their potential, we think the easiest and most effective way is to ease and rationalize their regulations as recommended below.

Recommendations:

* The current practice of margins needs to be thoroughly rationalized such that Futures are not subject to discriminatory margins.

* Eliminate settlement by delivery, unless counter parties agree on delivery off-exchange.

* Eliminate the requirement of possession of shares for selling in Futures.

* Possibilities should be explored to include more shares and have more contract types.

* Index trading needs to be initiated. The KSE needs to devise a separate Index and provide the appropriate clearing and settlement, etc.