Page 223 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes Four years have elapsed since the LCGC Report of March 1998. During this period there have
been several significant changes in the structure of the Indian capital markets which include,
dematerialisation of shares, rolling settlement on a T+3 basis, client level and Value at Risk
(VaR) based margining in both the derivative and cash markets and proposed demutualization
of exchanges. Equity derivative markets have now been in existence for two years and the
markets have grown in size and diversity of products. This, therefore, appears to be an appropriate
time for a comprehensive review of the development and regulation of derivative markets.

11.2.1 Regulatory Objectives

It is inclined towards positive regulation designed to encourage healthy activity and behaviour.
It has been guided by the following objectives:
1. Investor Protection: Attention needs to be given to the following four aspects:
(i) Fairness and transparency: The trading rules should ensure that trading is conducted
in a fair and transparent manner. Experience in other countries shows that in many
cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In
this context, sales practices adopted by dealers for derivatives would require specific
regulation. In some of the most widely reported mishaps in the derivatives market
elsewhere, the underlying reason was inadequate internal control system at the
user-firm itself, so that overall exposure was not controlled and the use of derivatives
was for speculation rather than for risk hedging. These experiences provide useful
lessons for us for designing regulations.

(ii) Safeguard for clients’ moneys: Moneys and securities deposited by clients with the
trading members should not only be kept in a separate clients’ account but should
also not be attachable for meeting the broker’s own debts. It should be ensured that
trading by dealers on own account is totally segregated from that for clients.
(iii) Competent and honest service: The eligibility criteria for trading members should be
designed to encourage competent and qualified personnel so that investors/clients
are served well. This makes it necessary to prescribe qualification for derivatives
brokers/dealers and the sales persons appointed by them in terms of a knowledge
base.
(iv) Market integrity: The trading system should ensure that the market’s integrity is
safeguarded by minimising the possibility of defaults. This requires framing
appropriate rules about capital adequacy, margins, clearing corporation, etc.
2. Quality of Markets: The concept of “quality of markets” goes well beyond market integrity
and aims at enhancing important market qualities, such as cost-efficiency, price-continuity,
and price-discovery. This is a much broader objective than market integrity.

3. Innovation: While curbing any undesirable tendencies, the regulatory framework should
not stifle innovation which is the source of all economic progress, more so because financial
derivatives represent a new rapidly developing area, aided by advancements in information
technology.

11.2.2 Hedging

The term ‘hedging’ is fairly clear. It would cover derivative market positions that are designed
to offset the potential losses from existing cash market positions. Some examples of this are as
follows:

An income fund has a large portfolio of bonds. This portfolio stands to make losses when
interest rates go up. Hence, the fund may choose to short an interest rate futures product
in order to offset this loss.

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