FUTURES & OPTIONS

Shayna Hutchins, Nermin Jasani, Regina Malta, & Kim Thrun

Agenda

What are Futures & Options? Regina

Current Regulation Kim

Exchanges vs. Over-The-Counter Shayna

Clearing Houses Shayna

SEC vs. CFTC Nermin

Other Proposed Regulations Nermin

F&O in BRIC Countries Regina

The Original Futures Market

The futures/forward market began in the mid-19th century with the establishment of central grain markets

Farmers could sell their products either for immediate delivery (spot market or cash market) or for forward delivery

Trading began with floor trading of traditional commodities such as grains, meat, and livestock

Forward and Futures Contracts Forward contracts were private contracts between

buyers and sellers and eventually evolved into today’s futures contracts

Both forward contracts and futures contracts are legal agreements to buy or sell an asset on a specific date

Forward contracts are negotiated directly between a buyer and a seller and settlement terms vary from contract to contract

A futures contract is facilitated through an exchange, and is standardized according to quality, quantity, delivery date, and place The only remaining variable to be determined is price

Although some futures contracts result in the actual delivery of the asset, others require cash settlement in lieu of delivery Most futures contracts are liquidated before they are delivered

Today’s Futures Market

Today exchange traded futures have expanded to include metals, energies (crude oil, gasoline heating, natural gas and oil), currencies (U.S. and foreign), interest rates, equity indexes (U.S. and foreign), and treasuries

The majority of trades are now made electronically, but are still made on the floor of the exchange

At any moment some traders are willing to buy and other traders are willing to sell, making the futures market very efficient

Oversight of Futures Contracts In order to ensure the integrity of the

market, all futures contracts are reviewed by the Commodity Futures Trading Commission (“CFTC”)

The contract must comply with the requirements of the Commodity Exchange Act and the CFTC’s regulations

The CFTC conducts daily market surveillance, and can order specific action to be taken to ensure the financial and market integrity of the exchange

Who Trades Futures?

Most of the trades made in the futures markets are done by hedgers or speculators

Hedgers Use the futures markets to reduce their exposure to

adverse price movements by transferring their risk to others Their goal is long term price certainty

Include agricultural companies, mining firms, banks and others that want to protect themselves against rising prices of products that they need to sell

Other hedgers are manufacturers, food processing companies, financial firms and others that want to protect themselves against rising prices of products that they need to buy

Who Trades Futures?

Speculators Include hedge fund managers, banks,

proprietary trading firms and individual traders

They accept price risk in the hope that they will profit from correctly anticipating the market’s price movement and direction

What are Options?

The holder of the futures option gives them the right, but not the obligation, to buy or sell a futures contract at a specific price, called the strike price or exercise price

The reason why someone would buy an option is because they think that the price of the futures contract will be higher or lower in the future

Types of Options

Call Option Gives the holder the right to buy the futures

contract at the strike price If you think that the price of the futures contract

will be higher in the future then you would purchase a call option

Put Option Gives the holder the right to sell the futures

contract at the strike price If you think that the price of the futures contract

will be lower in the future then you would purchase a put option

Options Pricing & Maturity

The price paid for the option is called a premium

Options have an expiration date If the option is an American Option you can

exercise the option on any day up until the expiration date

If the option is a European Option it is only exercisable on the expiration date

FUTURES & OPTIONS:CURRENT

REGULATION

Kim Thrun

Federal Regulation

Commodity Exchange Act (CEA) (1974) Creates and defines role of Commodity Futures

Trading Commission Authorized creation of National Futures

Associations Significantly amended by: Commodity Futures

Modernization Act of 2000 Fundamental aim of regulation

Help protect market users and the public from fraud and manipulation and to ensure fair and orderly markets

Important Historical Regulations & Legislation

1981 CFTC requires exchanges to set speculative position

limits in all futures contracts in reaction to the attempt by William Herbert and Nelson Hunt to corner the silver market

1991 CFTC grants a “bona fide hedging” exemption which

allows hedgers with a legitimate business commodity to not be constrained by positional Limits

2000 Commodity Futures Modernization Act, exempts most

OTC derivatives from regulation (this provision coined ‘the Enron Loophole’)

Eventually blamed for contributing to the meltdown of the US financial markets

Federal Regulation

Commodity Futures Modernization Act of 2000 (CFMA) Amended the CEA Excluded trading of most OTC financial derivatives and

transactions between sophisticated counterparties (i.e. eligible contract participants & excluded commodities)

Exclusion of hybrid instruments that are chiefly securities (Predominance Test)

Repealed the ban on single-stock futures & implemented regulations for the products

Created a three-tiered structure for the trading of derivatives that distinguishes among markets based on the types of contracts traded and the sophistication of the market participants.

Regulating Bodies

Commodity Futures Trading Commission (CFTC) Regulates all US futures Exchanges

Exclusive jurisdiction over contracts for the sale of an asset for future delivery and options on such contracts

Growth of the Futures Market and Financial Derivatives have tested this exclusive jurisdiction & Futures/Securities regulation line became muddied

1981: Shad-Johnson Accord/Futures Trading Act of 1982

Regulatory Agency with the power seek Criminal Prosecution by the DOJ

Senate and House Agricultural Committees oversees the CFTC

Executive Structure: 5 Commissioners, elected to 5 year terms by the President,

with advice and consent of the Senate, President designates one to serve as Chairman, with confirmation from the senate

Regulating Bodies

National Futures Association (NFA) Congressionally authorized self-regulatory organization subject to

CFTC oversight Individuals and firms that engage in futures business with the

public are required to be members of NFA : Futures Commission Merchants Introducing Brokers, Commodity Trading

Advisors, and Commodity Pool Operators Responsible for registration as required by the CFTC, including

exchange floor brokers and traders Brokers and Traders must be separately licensed to trade in

commodities Regulates – The Parties: protect investors from fraud – mediation

and arbitration for consumer complaints The Exchange

Sets own requirements and rules, similar to the stock-exchanges Violation of Exchange Rules can result in fines, suspension, or

expulsion

Clearing Organizations

Clearing Organizations Entity that clears and settles futures and

derivatives transactions Also, assures the proper conduct of each

contract’s delivery procedures and the adequate financing of trading

May be a division of a particular exchange, an affiliate, or a freestanding entity

Required to register with the CFTC in order to clear transactions

Ongoing compliance with 14 core principles

Intermediaries

In general, intermediaries must register with the CFTC

Subject to a wide range of disclosure, reporting, recordkeeping, and ethical requirements, depending on the nature of their activities

Futures Commission Merchants (FCM) Introducing Brokers Commodity Pool Operators Commodity Trading Advisers Floor Brokers and Floor Traders

Risk-Based Tier Structure Regulations

Multi-tiered approach to oversight based on the nature of the underlying commodity, the participants trading, and the manner of the trade

Market Categories Designated Contract Markets Derivatives transaction execution facilities, and Exempt markets

Product Categories: Excluded Commodities Exempt Commodities Agricultural Commodities

Excluded Commodities

Financial Commodities Interest rates, currency prices, credit rating, debt instrument;

any economic or commercial index other than a narrow-based commodity index or commodities that have no cash market

Not susceptible to price manipulation because of large scale No cash market

Commodities are called excluded because they are not subject to regulation if they are (1) between Eligible Contract Participants and (2) are not traded on an official trading facility

Because many of these products are large in scale, such as derivatives on economic indicators or weather, they are considered beyond the influence of interested investors

Exempt Commodities

Definition: “The term “exempt commodity” means a commodity that is not an excluded commodity or an agricultural commodity.” 7 U.S.C.A § 1a

Primarily metals and energy commodities This is the provision referred to as the “Enron

loophole” – recently closed: Farm Bill HR 2419 (2007) The transaction in the exempt commodity must be

entered into (1) between Eligible Contract Participants an not traded on a Trading Facility or (2) between Eligible Commercial Entities on a principal-to-principal basis through an Electronic Trading Facility

Still subject to fraud and manipulation provisions

Agricultural Commodities

All derivatives based on farm commodities must be traded on a CTFC-regulated exchange Concerns about price manipulation

Readily identifiable cash market Limited Supply Significant Price Discovery function

Eligible Contract Participants Eligible Contract Participants

Whether a transaction qualifies for an exclusion under the CFMA often depends on whether the transaction is between “Eligible Contract Participants”

Based on regulated status or amount of assets Financial Institutions Insurance Companies Investment Companies Commodity pools with assets over $5 million Business that (1) has assets over $10 million, (2) transactions are guaranteed by another eligible

contract participant, OR (3) if the transaction related to the business, the businesses net worth is over $1 million

Employee benefit plans with over $5 million and have investment decisions made by independent advisers

Government entities that (1) transact with other eligible contract participants (2) own and invest on a discretionary basis over $25 million, OR (3) regularly enter into transactions with respect to the underlying commodity

Broker-Dealers Futures Commission merchants Individuals with total assets over $10 million – or $5 million when the transaction involves risk

management Any other person determined eligible by the CFTC Those acting on behalf of an Eligible Contract Participant

Eligible Commercial Entity An Eligible Contract Participant OR other entity approved by the CFTC

Designated Contract Markets (DCMs)

Highest Level of CFTC Regulatory Oversight Characteristics:

The traditional organized futures exchanges or boards of trade – physical or electronic

Offer the widest range of products – essentially on any type of asset, index, or instrument

Open to all types of market participants: institutional & retail Regulations:

Exchanges must apply for the DCM designation. Qualifications: the ability to prevent market manipulation, rules to

ensure fair and equitable trading, rules for operation of the trade execution facility, financial integrity of transactions, public access to rules and contract specifications, and the ability to obtain the information necessary to perform required functions.

Must demonstrate ongoing compliance with the 18 established principles

Exempt Commercial Markets/Electronic Trading Facilities

Least Regulated by the CFMA – exempt from most requirements of the CEA (except still subject to antifraud and manipulation provisions)

Highest Restrictions on the types of commodities that may be traded and who may participate – Exempt Commodities on a Principal-to-Principal Basis between Eligible Commercial Entities Metals & Energy

Must notify the CFTC of the intention to operate within the exemption

No clearing requirement, but many choose to have/provide a clearing function

Generally – these are the platforms for the trading of OTC derivatives

Regulation of Electronic Trading Facilities/Exempt Commercial Markets

This is the market where the “Enron loophole” allowed energy companies to trade without positional limits – recently limited: Farm Bill HR 2419 (2007) Amended CEA, providing for the CFTC regulation of Electronic

Trading Facilities that offer “significant price discovery contracts” in commodities Price Discovery: The process of determining the price level for a

commodity based on supply and demand conditions. Price discovery may occur in a futures market or cash market.

Essentially, if the supply and demand functions serve to determine the price of the underlying commodity or contract, or effect other market prices

Can happen when the ECM’s prices are routinely disseminated or quoted

If the contract meets any of the criteria, the electronic trading facility becomes subject to exchange-like regulation, meaning the facility will have to comply with exchange-like regulation

Price Discovery, Hedging, & Speculation

Price Discovery is an important function of the Futures Market – by influencing demand and supply for futures contracts the price is determined – transparency is important in this respect

Economically, Futures Trading is a zero-sum game for participants – someone wins and someone looses Fundamentally, hedgers may be “happy” to lose because this loss is

the cost of the insurance function Default is less likely when futures are used in an insurance function Also – in this respect, futures provide stability in a volatile market

Speculation also plays an important role in the market While hedgers come to the market to alleviate risk, speculators come

to the market to take on that risk Often compared to gambling because phenomenal fortunes have been

made and lost CFMA has provisions that preempt state laws that would classify futures as

gambling Speculation , while often evoking a negative connotation, actually adds

liquidity to the market

Speculation

Competition among speculators provides an efficient market – moves closer to the prefect competition model: liquidity in the market drives down spreads Allows hedging to occur at a lower price and alleviates

much of the counterparty search problems Information is incorporated swiftly and leads to

efficient price discovery Reason why stock-index futures are attractive, they

move in tandem with the underlying stocks and are cheaper to buy and have a lower tax structure in some cases

Extreme efficiency is demonstrated – stock-index prices often change before the underlying stock prices do

Speculation – Negative Aspects Speculation can cause prices to deviate from the intrinsic

value if speculators are trading on misinformation Speculation can lead to the Creation Positive Feedback

Loop – (Creation of an Economic Bubble): price rises due to speculation can cause further speculative purchasing

Too many speculators demanding push the price of the underlying commodity upwards Blamed for recent (2007-2008) increases in food and oil

prices Change in traditional producer-consumer hedging transaction

to current producer/consumer/speculator-speculator is blamed for causing unnatural multiples in the market (market much larger than necessary to successfully hedge) *

Fueled by non-delivery settlement – not required to deliver the underlying commodity

Convergence-demand effects

Importance of Closing the Loophole Fundamental Fairness Ability of Regulators and the Market to

Stop/Regulate Bubbles

Regulations

Margin Regulations Futures Contract

Initial usually around 5% to 15% based on volatility Maintenance usually 75% of the Initial Mark to Market rule does not apply to Hedging Transactions Margin rules differ across the various option exchanges: For the Chicago Board of Trade and the Chicago Mercantile Exchange,

the Futures margin is determined by the SPAN margining system, which takes into account all positions in a customer’s portfolio

Standardized Contracts Type, Quality, Quantity

Non-delivery settlement Until 2000, futures transaction were required to occur on

registered or regulated exchanges – off-exchange trading of futures were banned NOW: Risk-based tiered approach to regulation

New Regulations

Greater transparency in Exempt Markets Including Intercontinental Exchange (an ECM) contracts in the

Commitments of Traders Reports “The Commitments of Traders (COT) reports provide a breakdown of

each Tuesday’s open interest for market reports in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC.” - http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm

Regulation of off-shore contracts based on US products CFTC & UK Financial Services Authority reach a deal to tighten

oversight of energy markets Raised Capital standards for commodity brokers & requiring

firms to incorporate OTC derivatives positions into their risk-based capital calculations (CFTC rules finalized Dec 31)

Consequences for Failure to Follow Regulations

Violation of the NFA rules of professional ethics and conduct, failure to comply with financial and recordkeeping requirements – Can result in a permanent bar from engaging in any futures-related business

FUTURES & OPTIONS:EXCHANGES VS. OVER-THE-COUNTERCLEARING HOUSES

Shayna Hutchins

Exchanges

Futures Contracts Standardized

Underlying asset Contract size/units Place Maturity Counterparty

Contracts between intermediaries, separate buyer and seller

Deliver to the exchange, not to a specific party Used for short term hedging

Exchanges

Party 1Corn Farmer

ExchangeCBOT

Party 2Ethanol

Producer

CME Group CME – Chicago Mercantile Exchange CBOT – Chicago Board of Trade NYMEX – New York Mercantile Exchange

CBOE – Chicago Board Options Exchange

Over-The-Counter Markets

Forward Contracts Individually tailored to a particular risk Direct contract between buyer and seller Prices derived from exchanges

Price discovery on exchanges keep OTC markets and forward contracts in line with futures prices

Good for hedging against long-term investments Ex) Stream of foreign currency

Over-The-Counter Markets

Party 1Corn Farmer

Party 2Ethanol Producer

Broker

Exchanges vs. Over-The-Counter

Exchanges High liquidity High transparency Low risk

OTC More flexible Low liquidity Low transparency* Higher counterparty

risk* High risk

Problems with OTC Markets

Transparency Availability of information

Price, volume, contracting parties Evaluating and managing risk

Counterparty credit risk default risk Systemic risk

Interconnections and contracts between firms The Domino Effect

The Domino Effect

Speculator

Corn Farmer

Corn

Farmer Ethano

l Produc

er

Corn Farmer

Kellog’

sSpeculat

or

Orville

Problems with OTC Markets

Counterparty risk OTCs deal with counterparty risk by setting

privately negotiated collateral requirements Not standardized Doesn’t take credit risk or exposure into account Because no transparency/availability of information Difficult to evaluate

Actual risk depends on actual deals being done Possibility of certain firms cornering the market

Market Concentration Creates systemic risk

Market Concentration (OTC)

Orville Redenbach

er

Ethanol Producer

Corn

Farmer

(seller)

Livestock Farmer

Kellog’s

Market Concentration (Exchange)

Orville Redenbach

er

Ethanol Producer

Corn

Farmer

(seller)

Livestock Farmer

Kellog’s

Speculator

Hedger

Proposed Solution: Centralized Clearing

When OTC markets become large enough to significantly impact the overall financial system, they need to have centralized clearing in order to aggregate the information on outstanding deals and risk exposures for the benefit of regulatory authorities and other market participants

3 different types of central clearing offer different levels of market integration

and transparency

Types of Centralized Clearing 1. Deals Registry

Most basic arrangement Registry of deals in which counterparties report

trades Public disclosure of trading information Leads to more accurate pricing and safer

collateral requirements Creates incentive for sellers to limit risk exposure Investors, regulators, and financial institutions

can better analyze and hedge “true” risk Reduce systemic risk

Types of Centralized Clearing 2. Clearing House as Central Counterparty

Stronger form of clearing Takes on the role of counterparty and guarantor of

all contracts Similar to clearing house for a formal exchange

Deals are still individually negotiated, but are then split into 2 separate contracts and required to be registered with the clearing house in the middle of the transaction

Clearing house sets standardized margin requirements for all contracts

Still offers access to multiple trading platforms

Types of Centralized Clearing 3. Formal Exchange

Strongest and most centralized form of market organization

High transparency Offers highly visible prices and volumes

Allows broad market participation Minimizes counterparty risk through standardized

margins and contract guarantees supported by the capital of both the clearing house and independent market makers

Creates problem of standardizing complex instruments Not a one-size-fits-all solution Compromises flexibility of the contracts

High cost of setting up and running an exchange Not suitable for thinly traded instruments

Policy Recommendations

Trade disclosure to promote transparency Balance information with confidential trading

strategies Centralized organization

Assume role of counterparty and guarantee trades

Reduces risk and increases transparency Importance of non-standardized instruments Compromise: Clearing House as Central

Counterparty is the favored solution

Clearing Houses

Acts as an intermediary between buyer and seller Guarantees both buyers and sellers will

receive what they’ve contracted for Seller doesn’t have to worry about financial

stability of buyer Buyer doesn’t have to worry about product

of sellerParty 1Corn

Farmer

Firm 1Local Agri. Bank

Clearing House

Firm 2JP

Morgan

Party 2Ethanol Producer

Clearing Houses: Risk Minimization Margin requirements

Amount due varies based on market fluctuations Clearing house tallies up daily trades/contracts Mark to market daily Parties holding contracts that have fallen during the day are

required to pay the clearing house a sort of security deposit “Margin calls” Investors must be able to fulfill immediately

When the contracts are closed out at maturity, the clearing house pays the parties who contracts have gained in value

Futures trading is a zero-sum game: for every winner, someone loses an equal amount Ensures that risk associated with highest possible cost of closing

out a contract the next exchange day is completely covered Assumes most unfavorable change in the market of the positions

held

Clearing Houses: Risk Minimization Additional security measures

Instead of standing between 2 traders, the clearing house stands between 2 member firms

Each firm monitors its own customers and makes margin calls when necessary If a customer can’t fulfill the margin call, the firm closes

the account, sells off the positions, and may take a loss Firms pay attention to the credit of their customers Clearing house pays attention to the credit of the

firms Clearing house will only have to make good on a

trade if the losses are so great that the firm itself fails

Public vs. Private Clearing Houses Public Option

Government run May be more highly monitored Possibility of a government run monopoly

Private Option Used in Europe as a profit making business

Many institutional banks operate their own clearing houses

Each exchange in the U.S. has its own clearing house

Possibility of high fees injected into the OTC market Risky because they need to turn a profit

The Future of F&O Markets

Academic debate No current proposed regulation to set up

a mandatory clearing house for futures and options

Current action on clearing houses for derivatives Played a larger role in the financial crisis Viewed as riskier instruments

Wait-and-see approach

A Caveat: Where does the risk go?

Transfer of risk from banks to clearing houses

Either option will have to be backed by the government and has the possibility of becoming a “too-big-to-fail” institution if it is the sole clearing house

Option of creating multiple clearing houses that are in competition with one another

Competition can fuel risky behavior

Final Thoughts

Is this idea an example of the herding effect?

Does it create another moral hazard by passing off risk?

Party 1Corn

Farmer

Firm 1Local Agri. Bank

Clearing House

Firm 2JP

Morgan

Party 2Ethanol Producer

FUTURES & OPTIONS:THE SEC AND THE CFTCOTHER PROPOSED REGULATIONS

Nermin Jasani

Merging the SEC and CFTC

Why merge the SEC and the CFTC? Mainly because there is overlap between

both organizations with respect to products like OTC derivatives and their function in regulating the futures market and the stock market

What are the benefits of a merger?

Allow both the CFTC and the SEC to share information and prevent a future financial breakdown

Stronger oversight Eliminating turf wars Reducing delays in launching derivatives Eliminates the overlap Save on government expenditure with the SEC

and CFTC – proposed CFTC budget for 2010 is $177.7 million, and the proposed SEC budget for 2010 is $1.13 billion

Why shouldn’t they merge?

Merging them would be inefficient – SEC’s function to level the playing field, and CFTC’s function of hedging risk

Time consuming for Congress to re-write both the SEC and CFTC regulation

If there was a merger, SEC’s policies would prevail over the CFTC’s, which would be unsuccessful in regulating the futures market

Will the SEC and CFTC actually merge, or is this simply coffee talk?

Not anytime soon, they may merge some of their activities, but a complete merger is unlikely anytime soon

September 2009 – Geithner stated that he does not plan on merging these regulators, and it is not a priority

The House Bill and Senate Bill mention nothing about merging these regulators

Politics - Senate Agricultural Committee is unlikely to relinquish its power

Regulations proposed by CFTC to regulate F&O

POSITION LIMITS

What are position limits? Position limits are created for the purpose of maintaining

stable and fair markets. Contracts held by one individual investor with different brokers may be combined in order to gauge accurately the level of control held by one party

Purpose of position limits? Reducing volatility in the markets Reduce speculation Increasing transparency with respect to actual demand Limiting the number of futures/options contracts that one

party can hold – preventing corner’s in the market

Limits on energy futures and options

What includes “energy”? Natural gas, heating oil, crude oil and gasoline

Why have energy as the first position limit imposed by the CFTC? Increased energy prices in summer 2008 led Congress to

believe that energy traders were driving up the cost of energy This position limit is intended to reveal what actual demand for

energy is, which will provide a more accurate price for energy CFTC estimated that if the limit were adopted today a trader

could hold no more than 98,200 contracts of crude oil Will there be any exemptions for energy position limits?

Airlines and other companies who are hedging for business purposes will receive an exemption for this requirement

Will there be additional position limits?

CFTC is having a meeting on metals in March to begin discussing positional limits

H.R. 4173

What does the House bill have with respect to futures and options? Taxing futures and options transactions

Purpose of the tax? Fund the CFTC

Flaws of this proposed tax? Drive trading to less regulated and less

transparent markets (overseas), severely curtail market-making activity, and drive up the costs of hedging price risks

H.R. 4173

Requires the CFTC to establish hard limits on commodity trading both on and off exchanges

Already seeing it in the form of position limits

Forcing the SEC and CFTC to work together in creating rule-making authority. If they do not meet statutory deadlines, the Treasury will prescribe the rules. This threat is intended to force these agencies to work together, for once.

H.R. 4173

Futures Held in a Portfolio Margin Securities Account Protection:   The bill attempts to extend SIPC insurance

to futures positions held in a customer portfolio margining account under a program approved by the SEC.

Regulating the foreign exchange market

Forex limits: Leverage in retail forex customer accounts would

be subject to a 10-to-1 limitation, which means 10:1 leverage would be the maximum amount allowed for forex traders in the U.S.

This means that before you can purchase a lot of say 100k yen, you have to have a higher margin – i.e. pay 10k instead of 1k as a margin requirement.

Disadvantages – traders are not fond of increasing the margin requirements, which will reduce their yield; already discussing moving to off shore sources.

Flash orders in the options world Reducing flash orders in the options world:

While most attention has focused on flash trading on stock exchanges, such practices appear to be more prevalent on options exchanges, according to industry participants. On options exchanges, flash orders commonly go by different names, such as "step-up" orders.

High-frequency traders have increasingly been moving into the slower options-trading universe, traders say.

Hybrid Agency Liaison mechanism. Trades that go to the CBOE, which accounts for about one-third of all option-trading volume, can be frozen for about one-tenth of a second. That brief moment gives other traders on the exchange the opportunity to match the order at the national best bid offer, or NBBO, before it routes to another venue.

Other possible regulation

Treat futures like stocks and increase their transparency as the SEC requires

Heavier fines

Activity in F&O Markets

Total options trading volume for 2009 was 3,612,637,118 contracts. This surpasses 2008’s record year by 0.84

percent which saw 3,582,572,581 total options contracts change hands

Options Premium: $1.22 trillion, down from $1.9 trillion in 2008 as prices to buy options came down from the peaks seen at the height of the financial crisis

2009: total futures 587,977,047 2008: total futures 825,544,634

FUTURES & OPTIONS:EMERGING MARKETS(BRIC COUNTRIES)

Regina Malta

Futures in Emerging Markets BRAZIL

Exchanges: Brazilian Mercantile and Futures Exchange

(BMF) RUSSIA

Exchanges: Moscow Interbank Currency Exchange

(MICEX) Futures and Options RTS (Russian Trading

System) (FORTS)

Futures in Emerging Markets INDIA

Exchanges National Stock Exchange of India (NSE) Bombay Stock Exchange (BSE) Multi Commodity Exchange of India (MCX) National Multi Commodity Exchange of India

(NMCE) National Commodity and Derivatives Exchange

(NCDEX)

Futures in Emerging Markets CHINA

Exchanges: Dalian Commodity Exchange (DCE) Shanghai Futures Exchange (SHFE) Zhengzhou Commodity Exchange (ZCE) China Financial Futures Exchange (CFFEX)

Brazil: F&O Markets

Derivatives trading in Brazil began in 1917 on an exchange Most of the trades were in coffee and cotton

In 1997the three main derivatives exchanges merged to form a single exchange called the Brazilian Mercantile Futures Exchange (BMF)

Today, Brazil offers futures trading through both organized exchanges and over-the-counter (OTC) markets

The most actively traded futures contract in Brazil is the Interbank Deposits (DI) futures

Brazil: F&O Markets

The two main exchanges in Brazil are the BMF the Bovespa (Brazil’s stock and options exchange) The BMF is a self regulatory organization

The BMF derivatives exchange, located in Sao Paulo, is the 5th largest futures exchange in the world

The BMF decided to go public in 2007 and conducted an IPO

The Bovespa exchange, also located in Sao Paulo, is the 7th largest futures and options exchange in the world The Bovespa mostly trades options on single stocks and

options on stock indexes Both the BMF and the Bovespa offer electronic trading

Brazil: Clearing Houses

Clearing houses are used to clear exchanged traded futures contracts and also OTC traded derivatives (voluntary). The clearing house becomes the counterparty to every contract traded, and therefore fully assumes the credit risk of the contract.

The clearing house has AAA ratings because they are highly capitalized. Investors post collateral directly with the clearing house.

The clearing house has five-levels of capitalization which assures greater credit protection. 1. Customer margin2. The firm which brokered the trade.3. Clearing member to whom the broker is tied.4. Special Fund of Clearing Members.5. The BMF itself.

Margin requirements provide the greatest defense against contract default. Currently there are no collateral requirements in the OTC market, so most

transactions end up operating with no collateral at all, unless the parties chose to use the BMF clearing house.

The BMF clearing house has its own bank in order to facilitate the settlement and overall payment of the transaction conducted.

Brazil: OTC Markets

OTC markets are usually not very transparent due to lack of regulation on reporting and disclosure requirements. Brazil has established some reporting requirements for OTC markets trading. In order to be considered legally enforceable, every transaction must be reported to one of two central registration and confirmation organizations- the BMF or CETIP.

Because of the reporting requirements in the OTC market, Brazil has the most transparent OTC market in the world.

There are about 15-20 dealers in Brazil’s OTC derivatives market.

Unlike most markets, inter-dealer market transactions are conducted through the BMF instead of through OTC transactions. They then provide derivative instruments to their buys in OTC market. The result being that the markets are more interconnected and reduced credit exposure.

Brazil’s futures market allows for the price discovery for the real-dollar exchange rate and the interest rate.

Brazil: Hedging

One of the most important features of the market is that it allows for hedging the fluctuations in domestic market interest rates This is so important because Brazil has a

past history with very high inflation and high nominal interest rates

Hedging is also used to comply with environmental climate change requirements, by trading carbon futures contracts

Russia: F&O Markets

FORTS (Futures and Options on RTS) is the leading derivative market in Russia

Open Join Stock Company “Russian Trading System” Stock Exchange organizes trading on the FORTS exchange in Russia The clearing function for the derivative market is performed by the

Closed Joint Stock Company “RTS Clearing Center” FORTS is mostly run by the leading Russian brokerages and

investment banks Participants in the FORTS market are highly capitalized

investment companies and banks The range of futures contracts traded on FORTS is narrow

Futures contracts traded on the FORTS consists of the shares and bonds issued by major Russian companies, RTS Index, foreign currency, the average MosIBOR overnight rate, and MosPrime 3month rate

The commodities traded include Urals oil, gas oil, gold, silver, and sugar.

Russia: To Develop or Not to Develop?

The main reason for the underdevelopment of the Russian derivative market can be traced to the legal risk associated with the lack of regulation in the market

In the beginning Russian courts refused to recognize net payouts as a legal contract, and therefore they were unenforceable In 2007 these contracts were made enforceable provided that at

least one of the parties involved in the transaction is a Russian bank or a recognized participant of the market

Although this solved part of the problem, a huge reason why the Russian market is still having trouble expanding is that they are unfamiliar with the concept of close-out, or liquidation netting.

In 2009 after much debate, Russia finally a set of standard derivative contracts. The posting of collateral was also introduced. Although this was a big step forward in growing the Russian derivatives market, it is unclear how the participants will react to the new system.

India: F&O Markets

Futures Markets evolved in India in 1875 with the opening of the Bombay Cotton Trade Association Ltd.

The earliest futures contracts traded were groundnut, castor seed, and cotton

Futures trading in oilseeds soon followed In 1945 the East India Jute and Hessian

Ltd. was formed to conduct organized trading in both raw Jute and Jute goods

India: F&O Markets

In December 1952 Forwards Contract Regulation Act was enacted, which provided for a 3-tier regulatory system: An association recognized by the government to provide

recommendations to the Forwards Market Commission Forwards Markets Commission. Central Government

The Forward Contract Regulation Rules were established by the Central Government in 1954. The rules divided commodities into 3 categories based on the extent of regulation: Commodities under which futures trading can be organized under a

recognized association Commodities in which futures trading is prohibited “Free Commodities” which do not fall under the first two categories.

The association trading these commodities must obtain a Certificate of Registration from the Forward Markets Commission

India: Futures Market Re-Emerges Trading was pretty much halted altogether in the

1970s Futures trading was slowly reintroduced in the 1980s In 1991 the Government of India liberalized industries

in both the domestic and external sectors. Soon after another Committee was introduced to help expand the futures market

The Committee recommended futures trading in: Basmati Rice, Cotton and Kapas, Raw Jute and Jute Goods,

Groundnut, Rapeseed/mustard seed, cotton seed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils, Rice bran oil, Castor oil, Linseed, Silver, and Onions

India: Futures Market Re-Emerges Today, there are no restrictions on futures

trading in any commodity However, options trading in commodities are

prohibited Futures contracts are available in 1month,

2month, and 3month terms, and are settled on the last Thursday of every month Contracts are traded in lot sizes.

The Securities and Exchange Board of India also overlooks the activities of the Futures market, as well as the stock market

China: F&O Markets

Futures trading was first introduced in 1990 Futures trading in China is governed by the Administrative

Regulations on Futures Trading The China Securities Regulatory Commission, part of the State

Counsel Securities Commission, is the main policy implementation body

The China Futures Association (CFA) was established in 2000 to promote market development The CFA is a non-profit self regulatory organization. The CFA is

supervised by the China Securities Regulatory Commission. The authority of the CFA lies in its collective members which

include: brokerage firms, futures exchange special members and licensed individual futures traders

The CFA acts as a bridge between the futures market participants and the Government of China It implements laws, regulations and policies for the futures market,

while also maintaining the transparency and fairness of the market

China: Futures Exchanges

A futures exchange can be organized as either a membership organization or a corporation

China currently offers futures contracts in 19 commodities, with various new contracts being proposed

There is no futures option trading Chinese futures exchanges are required by law to enforce futures

margins requirements, price limits, position limits, large account position reporting requirement, risk reserve requirement, etc.

There are 165 futures brokerage companies in China. Companies that participate in the futures market must have their

clients sign a risk disclosure document with a client agreement and must also deposit futures margin requirement before starting to trade. These companies are also responsible for completing delivery procedures on behalf of their clients.

In 2009 the China Futures Association reported a futures trading volume of 130.51 trillion yuan, up 81.5% from the past year The largest trades were in copper, natural rubber and soybean oil.

QUESTIONS?

Shayna Hutchins, Nermin Jasani, Regina Malta, & Kim Thrun

FUTURES & OPTIONS