Derivatives Market at NSE

Trading Mechanism: The futures and options trading system of NSE, called NEAT – F&O trading system provides a fully automated screen based trading for S&P CNX Nifty futures on a nationwide basis and an online monitoring and surveillance mechanism. It supports an order-driven market and is accessed by two types of users: trading members and clearing members. The trading members (TM) have access to functions such as order entry, order matching, order and trade management while the clearing members (CM) use the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. They can also enter and set limits to positions which a trading member can take. At present, there are more than 200 derivative members on NSE. An investor has to sign a client broker agreement with a member of the derivatives segment before undertaking derivatives trading. A fresh agreement is not needed for options trading if an agreement is already signed for index futures trading. The investor has to pay a commission to his broker member on the value (strike price plus premium) of his contract. Brokerage rates range between 0.1 and 0.2 percent of the contract value. An option buyer does not have to pay margins but an option seller has to pay daily marked-to-market margins to the exchange. The broker member is required to give a contract note for all options and futures transactions done by an investor within 48 hours of the trade.

Clearing and Settlement: The National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all deals executed on the NSE’s derivatives segment. It acts as a legal counterparty to all deals on the derivatives segment and guarantees settlement. NSCL has developed a comprehensive risk containment mechanism for the derivatives market. The actual margining happens on a daily basis and online position monitoring on an intra-day basis.

Settlement System: Nifty Index futures are cash settled. Index options on the Nifty are European style, which means that they can only be exercised upon maturity. In case of futures, settlement is done on a daily basis by marketing to market all open positions on the basis of daily settlement price. Members are required to pay the mark-to-market losses T + 1 day. The contracts are finally settled on expiry of the Nifty Index Futures Contract. Index options contracts on Nifty have a daily premium settlement and a formal settlement on the exercise day.

Mutual Funds and Derivatives: SEBI has permitted mutual funds to trade in derivatives. Mutual funds can use derivatives only for hedging and portfolio balancing. Mutual funds have to hold the cash or underlying security equal to the total exposure they take in derivatives. Hence, there is no scope for speculation. In other words, mutual funds cannot use leverage.

The other guidelines of SEBI state that a fund’s offer document has to clearly state that the fund can use derivatives. The fund has to keep its trustees updated (informed) regularly. The mutual fund has to take an approval of the shareholders to take positions in the derivatives market.

Forwards and Futures:

Forward Contracts

A forward contract is a customized contract between two parties where settlement takes place on a specific date in the future at a price agreed today. They are over the counter traded contracts. Forward contracts are private agreements between two financial institutions and its corporate client.

Ina forward contract, one party takes a long position by agreeing to buy the asset at a certain specified date for a specified price and the other party takes a short position by agreeing to sell the asset on the same date for the same price.

The main features of forward contracts are:

1. They are bilateral contracts wherein all the contract details, such as delivery date, price quantity and so on, are negotiated bilaterally by the parties to the contract. Being bilateral in nature, they are exposed to counter party risk.
2. Each contract is custom designed in the sense that the terms of a forward contract are individually agreed between two counterparties. Hence, each contract is unique in terms of contact size, expiration date, and the asset type and quality.
3. As each contract is customized the contract price is generally not available in public domain.
4. The contract has to be settled by delivery of the asset on the expiry date.
5. In case, the party wishes to reverse the contract, it has to compulsorily approach the same counterparty, which being in a monopoly situation can command a high price.