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ChairmanSecurities and Exchange Commission of Pakistan

Islamabad

February 07, 2006

Subject: Report on the Feasibility of Exchange Traded Derivatives Market in Pakistan

Dear Chairman,

We are pleased to enclose herewith the report on the feasibility on the introduction of exchange

traded derivatives market in Pakistan with reference to the Notification No.

F.163/SECP/SMD/2005 of August 16, 2005.

With best regards,

Ali Ansari Chairman ________________________

Arif Mian Member ________________________

Mian Asif Said Member ________________________

Imran Iqbal Janjua Member ________________________

Imran Kamal Member ________________________

Nihal Cassim Member ________________________


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Feasibility of Introducing Exchange

Traded Derivatives in Pakistan

February, 2006


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Feasibility of Introducing Exchange Traded Derivatives in Pakistan

TABLE OF CONTENTS

EXECUTIVE SUMMARY...................................................... ........................................................... .................1

1.EMERGENCE OF DERIVATIVES................................................................................................................3

EXPERIENCE OF EMERGING MARKETS................................................................................................................4 1.1. KOREA .................................................................................................................................................4 1.2. MALAYSIA ...........................................................................................................................................6 1.3. BRAZIL.................................................................................................................................................7 1.4. INDIA....................................................................................................................................................8

2.RESULTS OF INTRODUCING ETD ..................................................... ........................................................9

2.1. REDUCING RISK,IMPROVING EFFICIENCY:...........................................................................................9 2.2. HELPING GROWTH OF OTCMARKET:..................................................................................................9 2.3. TRANSPARENCY: ...................................................... ........................................................... ...............102.4. PROMOTING FDI,INVIGORATING CAPITAL MARKET: ......................................................... ...............102.5. CURBING UNHEALTHY SPECULATION,EXPANDING MARKET: ...................................................... .....10

3.SUITABILITY OF EXCHANGE TRADED DERIVATIVES FOR THE PAKISTANI CAPITAL

MARKETS:.........................................................................................................................................................11

3.1. BENEFITS OF INTRODUCING ETD IN PAKISTAN ..................................................................................13 3.1.1 New Products for Channeling Liquidity and Growth .................................................... ...............133.1.2 Downside Protection.....................................................................................................................133.1.3 Liquidity........................................................................................................................................13 3.1.4 Leverage .......................................................................................................................................133.1.5 Short Selling..................................................................................................................................143.1.6 Hedging ........................................................................................................................................143.1.7 Retaining the Investor...................................................................................................................14

3.2. MARKET INFRASTRUCTURE................................................................................................................15 3.3. LEGAL INFRASTRUCTURE...................................................................................................................17

3.3.1. Legal Risk ........................................................... ........................................................... ...............173.4. EXCHANGE STRUCTURE .....................................................................................................................18

3.4.1. Fit and Proper .................................................... ........................................................... ...............183.4.2. Financial Capital Structure .................................................... ......................................................183.4.3. Governance Structure...................................................................................................................183.4.4. Exchange Infrastructure ......................................................... ......................................................193.4.5. Risk Management..........................................................................................................................193.4.6. Market Abuse & Independent Market Surveillance....................................................... ...............193.4.7 Non- Disclosure of Price Sensitive Information .................................................. .........................193.4.8 Funds in Protection ......................................................................................................................203.4.9 Clearinghouse...............................................................................................................................20 3.4.10 Management Structure: ................................................................................................................203.4.11 Compliance...................................................................................................................................20 3.4.12 Open Trading Rights .................................................... ........................................................... .....21

3.5. CLEARINGHOUSE STRUCTURE............................................................................................................21 3.5.1. Independent and Centralized ............................................................ ............................................213.5.2. Capital Adequacy of the Clearinghouse .................................................... ...................................213.5.3. Financial Safety and Integrity ......................................................................................................213.5.4. Central Counterparty (CCP) ............................................................ ............................................213.5.5. Clearinghouse Risk and Risk Management Strategies..................................................................22

3.6. INTERMEDIARIES................................................................................................................................23 3.6.1. The Need for Licensing ........................................................... ......................................................243.6.2. Business Plan................................................................................................................................243.6.3. Minimum Capital Requirements ....................................................... ............................................243.6.4. Trained Staff ....................................................... ........................................................... ...............253.6.5. Risk Management Systems ...................................................... ......................................................253.6.6. Addressing Conflicts of Interest....................................................................................................253.6.7. Ethical Standards..........................................................................................................................253.6.8. Compliance...................................................................................................................................26

3.7. INVESTOR PROTECTION......................................................................................................................26

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3.7.1. Account maintenance and Documentation ...................................................................................263.7.2. Client Profile ................................................................................................................................263.7.3. Segregation of Clients Assets ......................................................................................................273.7.4. Centralized Database of Defaulters..............................................................................................273.7.5. Unique Client ID...........................................................................................................................27

3.8. EDUCATION........................................................................................................................................27 3.8.1. Broker Education..........................................................................................................................273.8.2. Courses & Examination................................................................................................................273.8.3. Investor Education........................................................................................................................28

3.9. USERS OF DERIVATIVE PRODUCTS ......................................................................................................28 3.9.1. General Profile of Users...............................................................................................................283.9.2. Categorization of Users .......................................................... ......................................................28

4.PREREQUISITES, RECOMMENDATIONS & ROADMAP FOR INTRODUCING ETD....................29

SCOPE FOR FUTURE CONSIDERATION ...............................................................................................................30

Appendix I Broker Accreditation

Appendix II Stock Option Trade Life Cycle

Appendix III Relevant Terms

Appendix IV Options

Appendix V Correspondence

LIST OFTABLES

TABLE 1-TRADING ACTIVITY OF KOSPI200OPTIONS (TOTAL)19972004,MILLION KRW..5TABLE 2-KSEPERFORMANCE .............................................................................................................................11 TABLE 3-REQUIREMENTS OF A MARKET INFRASTRUCTURE.................................................................................17

LIST OF FIGURES

FIGURE 1BURSA MALAYSIA MONTHLY VOLUME &OPEN INTEREST ..................................................................6 FIGURE 2-TURNOVER OF DERIVATIVES MARKET ON NSE.....................................................................................8 FIGURE 3-KSE-100,2005 DAILY VOLATILITY (%)PROFILE................................................................................12 FIGURE 4-KSE-100,4YEARS DAILY VOLATILITY (%)PROFILE ..........................................................................12 FIGURE 5-CURRENT MARKET INFRASTRUCTURE.................................................................................................15 FIGURE 6-PROPOSED MODEL OF THE MARKET ....................................................................................................16

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TERMS OF REFERENCE

Exchange-traded derivatives markets are well established in the international marketplace.Within the Pakistani capital markets, there is a growing interest in exchange-traded

derivatives (such as futures and options). These products enable investors to invest insecurities through leveraged products as well as risk management tools. This warrants that aninitial study be conducted for the development of derivative products in our capital marketsbased on the international experience of developed and emerging capital markets. Toundertake this assignment the Securities and Exchange Commission of Pakistan has formed aCommittee comprising the following members.

MembershipMr. Ali Ansari Chairman

Mr. Arif Mian Member

Mian Asif Said Member

Mr. Imran Iqbal Janjua MemberMr. Imran Kamal Member

Mr. Nihal Cassim Member

Mr. M. Rashid SafdarPiracha

Secretary

The Committee was supported by Mr. Mohammad Ali Sheikh, who assisted in carrying outresearch, compilation, drafting and structuring of this report.

The committee was required to:

1. Research the needs that triggered and lead to the emergence of exchange-traded derivativemarkets in the international context with special reference to at least three distinct emergingmarkets where such products have recently started trading.

2. Study and specify the progress achieved by the emerging and developed markets after theintroduction of exchange-traded derivatives.

3. Study and recommend whether trading of exchange-traded derivatives is suitable for thePakistani capital markets in its present form. The study inter-alia should address aspectsconcerning market infrastructure, systems, risks, investor interest and education, users of the

derivatives products and other key matters.

4. Specify the probable and likely benefits for the Pakistani capital markets by introducing ortrading of exchange-traded derivative products.

5. Devise and recommend a plan (if required) for successful introduction of exchange-tradedderivatives for the Pakistani capital market. Such report shall cover any or all prerequisitesthat must be met prior to introducing such products.

6. Study the exchange-traded derivatives products as an alternative to badla financing.

7. Perform or include any other ancillary item or task to form part of the mandate and forwhich purpose it may increase the number of members on the Committee or nominate anyperson(s) to serve as member(s) on the Committee.

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COMMITTEE MEMBERS

MR.ALIANSARI

Mr. Ansari earned BA (Hon.), Business Administration & Economics majoring in Finance,from Richmond College (London, England) in 1985 and received Investment Management

Programme Certification from London Business School in 1988. His secondary schoolingwas at Seaford College (Petworth, England) and Karachi Grammar School (Karachi,Pakistan).

Ali Ansari is the former CEO of AKD Securities. He has also been considerably involved inthe securities market reform process and has previously served on the following committees:SEC Risk Management System for Stock ExchangesSEC Short Selling Regulations (Chairman)SEC Review of COT (Chairman)KSE Index Trading (Chairman)

Alis current focus is on Investment management, in particular Venture Capital and PrivateEquity. He serves on the boards of DV Com, Oil & Gas Investments and AKD InvestmentManagement (Chairman). Prior to his present position Mr. Ansari was based in London withCredit Lyonnais Securities (CLS) as Chief Operating Officer (Emerging Europe, Middle East& Africa - EEMEA). At CLS Asia headquarters in Hong Kong he pioneered the highlysuccessful CLSA.COM, one of worlds first fully functional intranet and extranet deliveringcompany and research information. He joined CLSA as Chief Executive Officer & Head ofResearch CLSA Pakistan.

MR.ARIFMIAN

Mr. Arif Mian is a Chartered Accountant from Institute of Chartered Accountants in Englandand Wales. He is also a Chartered Financial Analyst (CFA) and holds a Masters Degree inEconomics from University of the Punjab, Lahore.

Currently he is an Executive Director with the Securities Market Division of the Securitiesand Exchange Commission of Pakistan (SECP). Prior to joining SECP he was with theInvestment Dealers Association of Canada, the regulator of brokerage industry in Canada.Prior to that he was Director Risk Management with Canadian Derivatives ClearingCorporation and Risk Advisor to the Winnipeg Commodities Exchange and ExecutiveDirector Treasury Balance Sheet Management Division with CIBC.

Mr. Mian possesses extensive experience of equity and derivatives trading, risk ,managementand market regulation. He started his professional carrier with Whinney Murray, CharteredAccountants in UK, and has worked in financial institutions, in Hong Kong, Abu Dhabi,Saudi Arabia and Canada where he held positions of Chief Accountant, Manager Equities andDerivatives Trading, Portfolio Manager, Risk Manager and Treasury Financial Controller.

MR.IMRANKAMAL

Mr. Kamal has Masters in Business Administration from University of the Punjab and is aChartered Financial Analyst (CFA). Presently, he is Chief Executive Officer of CrescentBrokerage and Investment Services. He also served as Chief Operating Officer at SafewayMutual Fund Limited. Mr. Kamal also provided consultancy in certain Asian Development

Bank funded projects. He served as Senior Vice President and Senior Investment Manager atIslamic Investment Bank and Spencer Securities respectively. He was also the BranchManager at UBS Securities and Khadim Ali Shah Bukhari & Co.

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MR.IMRANJANJUA

Mr. Janjua has 12 years market experience as a trader and strategist in over-the-counter andexchange-traded derivatives gained while working at various banks in New York includingLehman Brothers, The Bank of Tokyo, Asahi Bank, and Standard Bank. Imran has, over this

period, consistently provided multi-national corporate and institutional clients, NGOs,Commodity Trading Advisors, and Fund Managers with advice on investment strategy,policy, execution, exposure management and market perspectives. Imran was alsoresponsible for establishing the FX Options Trading Desk at Asahi Bank Ltd, New York. In2003, he joined Habib Bank Limited as SVP and Head of Derivatives to establish a tradingand strategy desk focusing on the needs of local and multi-national clients. Since arriving inPakistan, Imran has also been extensively involved in educating banking and financeprofessionals through various professional (Institute of Chartered Accountants of Pakistan,the Institute of Bankers of Pakistan) and academic forums (Lahore University ofManagement Sciences, Institute of Business Administration). Mr. Janjua is presently SeniorVice President at United Bank Limited.

MR.MIANASIFSAID

Mr. Said has done M.Sc. in Economics and MBA in Finance & Accounting from CornellUniversity, NY. He has 33 years of professional and multi-faceted experience of three keyindustries financial services, foods, and textiles.

Currently, he is Chairman, Cornell Consultants, which specializes in business strategy,financial services, and corporate restructuring. Prior to this he was the Chairman & CEO,National Development Finance Corporation (NDFC) and Industrial Development Bank ofPakistan (IDBP). He served as SEVP & Group Executive, Habib Bank Limited (HBL) andChairman, Training Committee. Mr. Said was also Managing Director (CEO) of Haleeb

Foods Limited, Lahore and Chairman, Pakistan Dairy Association. Before that he wasManaging Director (CEO) of Gulf Denim Limited, UAE. He was also Vice PresidentCitibank N.A. Dubai, UAE running the Middle East Corporate banking and Treasuryoperations of the bank.

MR.NIHALCASSIM

Mr. Cassim is currently working as an independent Corporate Finance and StrategicConsultant. Prior to coming to Pakistan in 2004, he was involved in the acquisition of FirstAssociates Investment, Inc in Toronto, Canada and later held several positions at that firmincluding Associate Investment Banking, Head of Equity Syndication and resigned as VicePresident and Head of Small Cap Investment Banking for the firm Eastern Canadian

Operations. At First Associates he conducted several transactions in M&A, equity financingand corporate finance advisory. Prior to this Mr. Cassim had been responsible for thecorporate development of TVX Gold, Inc and was involved in its $4 billion merger withKinross Gold. Prior to his investment banking career at HSBC, Canada, he was an analyst onboth the buy side and sell side in the securities industries in the US, Canada and Pakistan. Mr.Cassim is an MBA in Finance and MIS from McGill University Canada.

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EXECUTIVE SUMMARY

Exchange-traded derivatives ETD (Futures and Options) on currencies, interest rates, andequities began to be actively traded on derivatives exchanges in most industrialized countries

in the 70s and 80s. Derivatives exchanges contribute towards the development of thefinancial infrastructure of a country by providing links between cash markets, hedgers andspeculators. The primary purpose of a derivatives exchange is to provide liquidity and pricediscovery mechanisms to transfer the underlying risks among players with varying roles in aneconomy. The need for establishment of derivatives exchanges is primarily motivated byeconomic and financial reasons, and also for reasons of national pride, especially in the caseof several emerging economies.

The experience of four emerging markets namely Korea, Malaysia, Brazil and India revealsthat innovation and growth in derivatives activity over the past 15 years has yieldedsubstantial benefits in terms of market expansion and overall economic growth. ETDs have

facilitated access of businesses to international capital markets, lowering their cost of fundsand diversifying their funding sources. Thus derivatives have improved the competitive

position of firms in an increasingly competitive global economy. Another prominent featureof centralized exchanges is information transparency which makes it possible to obtaininvaluable data on the commitment of traders. Emerging economies where index futures andoptions were introduced have experienced significant gains in both stock marketcapitalization and trading volume.

Despite phenomenal growth, Pakistani capital market has recently witnessed extra-ordinaryvolatility and is today one of the most volatile markets in the world. Following periodiccrashes at Karachi Stock Exchange (KSE) a number of investigations were carried out. They

have identified causes of aggravating market volatility. These including non-standard practices (when viewed from the perspective of international best practices IBP) anddeficiencies of Carry Over Transactions (COT Badla). However, irrespective of the reasonsfor excessive volatility no one can deny that it has led to systemic problems, marketmanipulation, and investor losses.

One of the patent reasons for such high volatility is the lack of hedging instruments that couldprotect the investors, both individuals as well as institutions. There is an undeniable need forderivative products that provide (1) down side protection to investors, (2) price discovery (3)and reduced dependence on Continuous Funding System (CFS Modified Badla) as the onlysource of leverage in the market. In view of the experience in other developing markets citedabove, and the current shortcomings of CFS, there is reason to believe that initiatingexchange traded derivatives will channel high risk capital, more players, products, andForeign Direct Investment (FDI) capital to our markets.

However, compared to the direction being taken in international markets, currently thePakistani capital market infrastructure is relatively nascent. Proper governance structure, riskmanagement and capital adequacy of the exchange, clearing participants and theclearinghouse is of the utmost importance. A sound market infrastructure will facilitate and

promote healthy growth of the derivatives market. Derivatives trading whether it occurs at anexisting exchange or at a new exchange should be in an environment that provides a level

playing field for all investors. Development of ETD will flourish when systems are in placeand conflicts of interest are eliminated.

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Derivatives are complex instruments which require sophisticated risk management systems.None of the operative exchanges have such systems in place. This report therefore sets outideal prerequisites and a proposed plan for the introduction of exchange traded derivatives.

RECOMMENDATIONS

The committee recommends introduction of Exchange-Traded Derivatives in Pakistanand strongly recommends the following prerequisites:

Adequate Legal, regulatory and governance infrastructure and oversight The SECP should allow for an open licensing regime so that existing or new

exchanges that meet the criteria can comply and qualify for derivatives trading. Functional Risk management framework Independent market and member surveillance Central counterparty, or operationally equivalent, clearing and settlement structure Effective enforcement by SRO and APEX regulator

The committee equally believes that the market intermediaries should be subject toindependent oversight of capital adequacy, professional proficiency and standards of

business conduct through a registration and licensing procedure.

It is essential that the current futures contract at KSE be brought into conformity withInternational Best Practices (IBP) both in its design and the environment in which it istraded. Similarly, as new derivative products are introduced it should be ensured thatthese too are in accordance with IBP.

ROADMAP

To translate its recommendations into a time-bound action plan, the committee proposesthe following road map for future development and introduction of derivatives in themarketplace:

The regulator should create and expand the legal infrastructure (including the draftFutures Trading Act).

Regulator, exchanges, and intermediaries should adopt best international practices forrisk management.

Regulator, exchanges, and intermediaries should build competent staff at all levels. Market infrastructure at all levels including exchanges, clearinghouses and

intermediaries should be upgraded. Phased introduction of derivatives, with single products at the initial stage, should be

as follows:o Introduction of 60, 90 and 180 days tenors for equity futures March 2006.o Introduction of Futures on acceptable equity index June 2006.o Introduction of Single stock call and put options with writing restricted to market-

makers of licensed exchanges June 2006.o Covered call and put options with writing restricted to qualified financial

institutions September 2006.o PIB and KIBOR index futures December 2006.

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1. EMERGENCE OF DERIVATIVESPrior to failure of the Bretton Woods regime in 1971, since exchange rates were fixed,currency and interest rate risks were not pressing concerns. However, significant events

thereafter, especially, the dramatic rise in volatility of the United States dollar against theJapanese yen, the excessive fluctuation in United States long-term bond yields, and the oilcrisis in the 1970s and early 1980s, all contributed towards creating an awareness of theimportance of corporate risk management.

This new found awareness led to the emergence of financial derivatives market. Futures andOptions on currencies, interest rates, and equities began to be actively traded on derivativesexchanges in most industrialized countries. The primary purpose of a derivatives exchangewas to provide liquidity and price discovery mechanisms to transfer underlying risks among

players with varying roles in an economy. The need for establishment of derivativesexchanges is primarily motivated by economic and financial reasons, and also for reasons of

national pride, especially in the case of several emerging economies.

The first recorded instance of futures trading is found in the 1700s in Shimonoseki, Japan,where merchants traded contracts on rice primarily to hedge against the risk of a decline inthe value of their crops before they were harvested.

In developed economies, trading in commodity derivatives preceded interest rate, currency,and equity derivatives reflecting the significance of commodities as contributors to economicdevelopment of those countries at that time as well as the extent to which markets for these

products were well developed. In the case of some emerging economies, however, sincedomestic stock markets were generally the first to develop, equity index futures and options

emerged prior to interest rate, currency, and commodity derivatives.

Historically, the introduction of derivative instruments followed the development of marketsfor the underlying instruments. Demand mainly came from domestic users. The advent ofequity derivatives followed the development of local stock markets and the popularity ofinterest rate derivatives gained as trading increased on local bond markets. In someinstances, the need for ETD arose to address market inefficiencies and/or to circumvent

prevalent restrictions. Some of these inefficiencies and restrictions include:

Counterparty riskIn markets where the Clearinghouses act as a Centralized Counterparty (CCP), by acting as

the buyer to every seller and a seller to every buyer, ETDs address the difficulty a participantmay face in identifying a suitable and creditworthy counterparty.

Counterparty inflexibilityETDs enable market participants to close out their positions with the exchange therebyeliminating the need to contact and persuade contract compliance by the counterparty to theoriginal trade.

Restrictive trading rules ETDs allow market participants to take short positions when short-selling is restricted in themain market for underlying securities.

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Complexity of trade executionWhere an investor possesses a multiple security portfolio, an index future contract enableshim to track a benchmark index, thus obviating the need to buy or sell the full set ofconstituent index stocks in the right proportion in the underlying market.

Trade barriersA derivatives exchange enables local market participants to overcome trade barriers such asunfair foreign exchange and tax regimes. In fact, the original Eurodollar contract at theChicago Mercantile Exchange was created in order to get around excessive constraints onforeign exchange transactions that were prevalent at the time under U.S. law.

Other auxiliary factors fueling the growth of exchange-traded derivatives in developed andemerging markets alike include:

A general trend towards outsourcing risk management to the capital markets (includingfor exchange-traded derivatives).

Increased participation from traditional (long only) funds, non-traditional (hedge) funds,and other institutional fund managers, due to growing competition and a requirement toenhance yields in a lower return environment.

Technological advances in pre-trade analytical software driving spread trading intra andinter markets.

End users are reviewing hedging policies in response to changes in InternationalAccounting Standards (IAS 39) and increasingly favoring standardized (exchange-traded)hedging instruments as opposed to OTC derivatives.

Counterparty risk reduction available in the futures market via a centrally novatedclearing corporation model (CCP).

Increased proprietary trading by investment banks in response to greater competition (forclient activity) and readily available and mobile capital.

EXPERIENCE OF EMERGING MARKETS

1.1. KOREAPrior to 1996, there were no exchange-traded derivatives in Korea. Now, by contractvolume, the Korea Stock Exchange is the worlds largest derivatives market. It isthe only Asia Pacific representative in the global top 10. The KOSPI 200 Indexoption which was introduced in 1997 is the contract that has brought fame to theKorea Stock Exchange. At first, its volumes were negligible, then in 1998 volumeexploded to 32 million contracts and doubled or tripled each year thereafter (see table

below).

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Table 1 - Trading Activity of KOSPI 200 Options (Total) 1997 2004, Million KRW1

Trading Volume

-Total

Trading Volume

-Daily Avg.

Trading Value

-Total

Trading Value

-Daily Avg.

ExerciseVolume

OpenInterest

2004 2,521,557,274 10,126,736 144,689,287 581,081 328079 2,782,724

2003 2,837,724,953 11,488,765 159,686,524 646,504 455094 3,102,844

2002 1,889,823,786 7,745,179 125,227,755 513,228 414912 4,845,491

2001 823,289,608 3,346,706 47,344,221 192,456 - 2,681,265

2000 193,829,070 804,270 16,620,835 68,966 - 536,818

1999 79,936,658 321,031 8,631,648 34,665 - 383,207

1998 32,310,812 110,653 2,226,770 7,625 - 205,764

1997 4,528,424 31,890 313,045 2,204 - 206,904

"No. of Listed Issues" and "Open Interests" are the quantity as of the end of each year or month.

Until the mid 90s, on account of pre-existing market restrictions, investmentopportunities for the Korean public were rather limited. But, with stock pricesdeclining as a result of the Asian Financial Crisis that surfaced in 1997, and the liftingof foreign investment ceiling on stock index futures and options in May 1998,investors were ready for something new. Whereas these regulatory changes increasedthe number of foreign participants dramatically, trading of the KOSPI 200 Indexoption became the predominant preserve of individual investors...accounting for morethan 64% of trading volume. The key attraction in the KOSPI 200 Index option overthe KOSPI Index Future (introduced in 1996) was the ability to profit from volatilitywhile risking the equivalent of a few US dollars on a deep out-of-the-money optionwhich could double or triple over the course of a few days.

The Korean government, keen to convert the country into a knowledge economy, alsoencouraged households to get online by making broadband internet access available tothem at very cheap rates. Brokerage houses, eager to ramp up commissions, alsoassisted electronic trading by providing clients with personal digital assistants almostfree of cost. As a result, Korean individual investors became the world leaders inonline trading. Korean securities firms gave further support to the KOSPI 200 Indexoption contract by offering seminars to their clients with a view to promoteunderstanding of options. They also provided liquidity to the retail market by writingoptions.

In sharp contrast to the Korea Stock Exchange, the participation of individual

investors on the Korea Futures Exchange (KOFEX) has been significantly lower.

Only 10% of volume transacted in interest-rate derivatives listed on the KOFEX isaccounted for by the retail sector. The major market participants in interest-ratederivatives trading on the KOFEX have been banks and investment trust companieseach accounting for 25% of volume. Here the motivation to trade has been basedmore on the need to hedge exposure in underlying assets such as Korean TreasuryBonds. USD Futures have also been actively traded on the KOFEX by domestic andforeign banks keen to hedge volatility risk in the exchange rate. In short, the Koreanretail investors are predominantly Options-oriented while institutional investors,

by and large, use Futures.

1 Source: Web site of Korea Stock Exchange

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1.2. MALAYSIAIn line with the countrys economic needs, the first derivatives exchange in Malaysia,The Kuala Lumpur Commodities Exchange (KLCE), was established in 1980 to tradecrude palm oil futures. However, due to large defaults in the market, trading was

suspended in March 1984. In 1985, trading resumed with the establishment of aclearinghouse, the Malaysian Futures Clearing Corporation. Thereafter, between1986 and 1990, several new commodities-focused contracts were successfullyintroduced.

Exchange-traded financial derivatives were introduced in the 1990s and two newexchanges-the Kuala Lumpur Options and Financial Futures Exchange (KLOFFE)and the Malaysian Monetary Exchange (MME)-were established. Unlike theircommodities counterpart, however, perhaps because of fragmentation of resources,these two new exchanges struggled to attract volume. The Asian Financial Crisisemerged as a harbinger of more bad news for KLOFFE and MME as Malaysian

authorities clamped down on the derivatives sector. In December 1998, KLCEmerged with MME to form COMMEX Malaysia. Then in December 2001,COMMEX merged with KLOFFE to form what is now known as the MalaysiaDerivatives Exchange (MDEX). The merger of exchanges addressed thefragmentation issue and made it easier for stock market intermediaries to tradederivatives. The introduction of electronic trading also had a positive impact ontrading volumes (see chart below).

Figure 1 Bursa Malaysia Monthly Volume & Open Interest2

While trading activity has improved significantly over the years, daily volumeremains below 300,000 contracts. At present, 8 contracts trade on MDEX (CrudePalm Oil Futures, Kuala Lumpur Composite Index Futures, Kuala Lumpur CompositeIndex Options, 3-month Kuala Lumpur Interbank Offered Rate Interest Rate Futures,

3-year Malaysian Government Securities Futures, 5-year Malaysian Government

2 Source: Bursa Malaysia Derivatives Berhad website

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Securities Futures, 10-year Malaysian Government Securities Futures, and CrudePalm Kernel Oil Futures).

However, the Crude Palm Oil Futures contract, originally launched in October 1980,remains the most successful commodity futures contract to-date. The relativelylukewarm response to financial derivatives in Malaysia compared with Korea may bedue to regulatory restrictions which bar foreign firms from participating in the marketas well as regulatory constraints on derivatives trading and short-selling. Judgingfrom the relatively better performance of the commodities contracts which are traded

primarily by institutions, it may also be the case that Malaysian individual investorstrading options were not given the kind of Governmental and institutional

support that was received by their Korean counterparts.

1.3. BRAZILIn 1917, Brazilian exporters, businessmen, and commodity producers collaborated toestablish the first Brazilian institution to offer derivatives, the Sao Paulo CommoditiesExchange (BMSP), in line with the countrys rich tradition in the trade of agriculturalcommodities such as coffee, live cattle, and cotton. In 1983, the Brazilian FuturesExchange (BBF) of Rio de Janeiro was established and in 1985 the Mercantile andFutures Exchange (BM&F) was founded. In 1991, BMSP and BM&F merged andkept the name BM&F. In 1997, the BBF also merged with BM&F with a view tostrengthen the domestic commodity market and consolidate what we know today as

Bolsa de Mercadorias y Futuros (BM&F) as the major derivatives trading center inMercosur.

The BM&F is the leading futures exchange in Latin America, and it is among thelargest exchange-traded derivatives market in the world as measured by the number ofcontracts transacted annually. The BM&F registers an average daily trading volumeof 758,000 contracts. Amongst emerging markets, only the Korea Stock Exchangesurpasses the BM&F in terms of number of contracts traded. The BM&F offers a richmenu of derivative contracts, which includes futures and options on agriculturalcommodities, the BOVESPA (Sao Paulo Stock Exchange) index, interest rates,foreign exchange rate, gold, amongst others. The BOVESPA, originally establishedin 1890, also offers derivatives such as options on 1-day interbank deposits, theBOVESPA index, US dollar denominated Brazilian equity, among others, however,volumes are significantly smaller relative to the BM&F.

In sharp contrast to the rest of the world where currency derivatives trading

takes place predominantly in the over-the-counter market, in Brazil, a significant

share of foreign exchange derivatives trading takes place at the BM&F. Anotherstriking dissimilarity between BM&F and most derivatives exchanges is that privateindividuals account for only 6.82% of volume. Financial institutions and institutionalinvestors constitute 62.41% and 18.43% of trading volume respectively.

Brazil is undergoing a process of rebuilding ethical standards all along the lines ofconduct, public and private, be it on the football fields, in the National Congress, orthe financial markets. Brazil provides us with a very fresh approach to managing aderivatives exchange. The BM&F performs back-office trade clearing and processingwhich is generally performed by member firms in most developed markets.Furthermore, they insist upon knowing the names and position holdings of all

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counterparties to transactions. This philosophy is unique to them as a result ofcorruption that has been so rife there and their determination to redress it.

1.4. INDIAExchange Traded Financial Derivatives were introduced in India on the NationalStock Exchange and the Bombay Stock Exchange in June 2000. A beginning wasmade with index futures contracts based on S&P CNX Nifty Index (Nifty) and BSESensitive Index (Sensex). Since then the turnover of derivative contracts have risen alot on NSE.

Figure 2 - Turnover of Derivatives Market on NSE3

NSE has around 99.5% market share of exchange traded financial derivatives in India.Stock futures and Index futures are two of NSEs most popular contracts, having amarket share of 59% and 29% (by turnover) respectively of the total derivativesmarket segment.

Commodity derivatives have been popular in India for a long time. The commodity

derivatives have functioned in India since the nineteenth century with organizedtrading in cotton through the establishment of Cotton Trade Association in 1875. Overthe years, there have been various bans, suspensions and regulatory restrictions onvarious contracts. As of July 2005, there are 25 commodity derivative exchangesin India with derivative contracts on nearly 100 commodities available for trade.The overall turnover is expected to touch Rs.5 trillion by the end of 2004-2005.

National Commodity and Derivatives Exchange (NCDEX) is the largest commodityderivatives exchange with a turnover of around Rs.30 billion every fortnight.

3 Data Source www.nseindia.com

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2. RESULTS OF INTRODUCING ETD2.1. REDUCING RISK,IMPROVING EFFICIENCY:The innovation and growth in derivatives activity over the past 15 years has yieldedsubstantial benefits to a number of economies. Derivative trading has facilitatedaccess of businesses to international capital, while lowering their cost of funds anddiversifying their funding sources. For participating firms, it has improved theircompetitive position in an increasingly competitive global economy.

By providing firms with new and more effective tools for managing their exposure tointerest rates, foreign exchange rates, and commodity prices, derivatives have alsoreduced the likelihood of financial distress due to volatile prices and interest rates.With these incidental risk exposures under control, management is better able to focus

on its core businessimproving the quality and reducing the cost of its product.Similarly, by providing investors and issuers with a wider array of tools for managingrisks and raising capital, derivatives improve the allocation of credit and the sharingof risk in the economy, reducing the cost of capital formation, stabilizingemployment, and stimulating economic growth.

2.2. HELPING GROWTH OF OTCMARKET:In developed and emerging economies alike, the establishment of centralized futuresand options exchanges has not only preceded the development of OTC markets, but,has also provided the impetus for growth in OTC derivatives trading. In the UnitedStates, interest-rate futures trading commenced on October 20, 1975, paving the wayfor the first OTC interest rate swap transaction in 1981. In Korea, the successfullaunch of KOFEX government bond futures on the Korea Futures Exchange providedthe stimulus for rapid expansion in OTC trading of KRW interest rate derivatives.Similarly, in Malaysia, the establishment of onshore derivatives exchanges facilitatedthe growth of over-the-counter derivatives.

From a functional perspective, organized derivatives exchanges serve theindispensable role of price discovery. For example, the volatility of a particular

underlying asset, which is a key input for pricing OTC options on that asset, isderived from option premiums of similar assets for various strike prices and maturitiesthat are traded on an organized exchange. OTC options traders rely heavily on thisinformation for pricing customized hedging solutions for their corporate clients.

OTC derivatives traders also utilize the exchanges extensively for liquidatingexposures received from clients as well as to capitalize on arbitrage opportunities that

present themselves during excessively volatile market conditions. In particular, whenthey measure the market risks associated with their activities, many financial market

participants, including the major banks and securities firms that serve as market-

makers for securities and OTC derivatives, assume that markets for exchange-tradedderivatives will provide sufficient liquidity to allow them to promptly offset their

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market risk exposures, even during episodes of market volatility when other financialmarkets may be relatively illiquid.

2.3. TRANSPARENCY:Another prominent feature of centralized exchanges is information transparencywhich makes it possible to obtain invaluable data on the commitment of traders.Trading volume, open interest, as well as the ratio of longs to shorts, divided betweencommercial and non-commercial entities, provides a very good perspective of themarkets overall position and profile. In contrast, OTC market data such as prices andother trading information is not made freely available to the public and can only beestimated through surveys conducted by the Bank of International Settlements.

2.4. PROMOTING FDI,INVIGORATING CAPITAL MARKET:Emerging economies in which index futures and options have been introduced haveexperienced significant gains in both stock market capitalization and trading volume.The introduction of derivatives has brought breadth and depth in the underlyingmarkets. It has also served to attract foreign direct investment (FDI) as it provides amechanism for foreign firms to hedge their exposure in emerging economies. InIndonesia, however, index derivatives have not gained favor primarily because theunderlying stock market itself remains underdeveloped.

2.5. CURBING UNHEALTHYSPECULATION,EXPANDING MARKET:In Korea, the introduction of exchange-traded stock index futures and options hasserved to satiate the appetite of the retail investor base and, perhaps, divertedspeculative tendencies away from the cash market. On the other hand, interest ratefutures have immensely benefited institutional players such as banks and investmenttrust companies in hedging the interest rate risk inherent in their money and bond

portfolios. The introduction of a diverse range of exchange-traded derivatives has alsoattracted foreign participation to the Korean markets. In terms of contract volume,foreign investors share in the KOSPI 200 Index Future contract has grown from amere 3% in 1996 to over 22% in 2004. Similarly, international participation in the

KOSPI 200 Index Option contract has increased from less than 1% in 1998 to over12% in 2004. On the KOFEX, foreign participation now accounts for 15% of contractvolume compared with an insignificant 1% of contract volume in 1998.

Brazils motivation to strengthen and promote its domestic derivatives exchange, theBM&F, has been driven by an overall focus on rebuilding ethical standards which had

been on the decline in that country. The BM&Fs infrastructure and policies havebeen designed with a view to promote transparency and prevent market manipulation.This strategy has proven immensely beneficial for Brazil not only in addressingethical issues but also in capturing the attention of the international community.Foreign investors now account for 11% of the total volume transacted on the BM&F.

The IMF, in its Global Financial Stability Report focusing on the role of financialderivatives in emerging markets makes special note of the BM&Fs superior riskmanagement framework by stating that:

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The BM&F follows state-of-the-art risk management procedures to deal with market

risk, liquidity risk, and counterparty risk. These procedures have helped the BM&F

to withstand several episodes of market turbulence, including the January 1999 crisis,

the Argentina crisis at the end of 2001

Exchange-traded derivatives have fostered the development and introduction ofinnovative interest-rate, equity, currency, commodity, and index derivatives which inturn has inspired the creation of alternative investments as an entirely new asset class.The hedge fund industry would most likely never have emerged as a dominant forcein the investment management arena if exchange-traded derivatives did not exist.

3. SUITABILITY OF EXCHANGETRADED DERIVATIVES FOR THE PAKISTANICAPITAL MARKETS:

The KSE-100 index ended the fiscal year 2004-05 with a gain of 41.1%, which translates into2,171 points increase in the index to 7,450. The index touched high of 10,303 on 15 th March2005. The market capitalization of the Karachi Stock Exchange surged to Rs.2,068 billion (ason 30th June 2004), depicting an increase of 45.53%.4 During the period under review, theKarachi Stock Market continued to be one of the five best performing markets around theworld. For a score of its leading scrips, it is an unusually liquid market. Against aninternational norm of 2 times, over the last one year, KSEs aggregate market capital turnedover 5 times.

Table 2 - KSE Performance

2004 2005 High Low

KSE-100 Index 5279 7450 10303 4890

Average turnover (Shares in Million) 389 343

Turnover (Shares in Million) 1086.55 62.95

Market Capitalization (in billions) Rs.1421 Rs.2068 Rs.2813 Rs.1346

Pakistan is an emerging economy and has a lot of growth potential. During 2004-05, realGDP grew by 8.4 percent, the fastest in two decades, making Pakistan the second fastestgrowing economy after China.5 However, the stock market in Pakistan has recentlywitnessed extra-ordinary volatility and is today one of the most volatile markets in the world.

Index volatilities across active global exchanges range between 15% and 25% p.a. Thistranslates into an average daily volatility of 1% to 1.5%6. Figures 3 and 4 on the facing pageshow that the comparative volatility for KSE is 200% to 300% of global average. LastMarch-April, it was as high as 300% of global average. Thereafter, it has been 75%-100%higher than global average. The 4-years profile confirms that KSE volatility has consistently

been above 1.5% except for the second half of 2004. Also, every year displays at least onebout of hyper-volatility.

4 In terms of US Dollars, the market capitalization was approximately US$ 35.65 billion at the close of the FY2004-05 which is an increase of US$ 11.35 billion over the previous year.5 Economic Survey of Pakistan 2004 05, Ministry of Finance, Pakistan6 Daily volatility can be converted into annual volatility by multiplying it with the root of the average number of

trading days in a year at the relevant exchange. The global average for trading days in a year is 252. Thus therelevant multiplier is 15.87 (=252).

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Figure 3 - KSE-100, 2005 daily Volatility (%) Profile7

Figure 4 - KSE-100, 4 Years daily Volatility (%) Profile7

Following periodic crashes at the KSE, a number of investigations were carried out. Amongseveral causes aggravating market volatility, including non-standard practices (at variancewith international best practices), they have all noted the deficiencies of COT (badla).However, irrespective of the reasons for excessive volatility, no one can deny that it has ledto systemic problems, market manipulation, and investor losses. One of the patent reasons forsuch high volatility is the lack of hedging instruments that could protect our investors, both

dividuals and institutions.in

ccordingly, there is an undeniable need for derivative products that provide:A

Down side protection to investors7 Source: National Commodity Exchange Limited (NCEL)

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Efficient and temporally stable price discovery, and Reduced dependence on CFS (modified badla) as the only source of leverage in the

market.

In view of the experience in other developing markets cited above, and the currentshortcomings of CFS as the sole source of leverage finance; there is reason to believe thatinitiating exchange traded derivatives will channel high risk capital to these markets and alsoattract more players and foreign direct investment capital, while simultaneously dampeningvolatility in the primary market.

3.1. BENEFITS OF INTRODUCING ETD IN PAKISTAN3.1.1 NEW PRODUCTS FORCHANNELING LIQUIDITY AND GROWTHModern capital markets around the world have grown with savvy investment

opportunities and tools. Exchange Traded Derivatives, which provide suchopportunities and tools, have played a major part in the growth of markets allover the world. Their introduction could have similar salutary impact on ourcapital markets.

3.1.2 DOWNSIDE PROTECTIONExchange Traded Derivatives work as a risk management tool for investors

because they can hedge (protect) their portfolio from a drop in value. Forexample, derivatives allow investors to hedge against a fall in the value of theunderlying asset. Looking at it from the perspective of the crisis in March

2005, such tools could have enabled investors to limit their downside risk.Derivative products conforming to international best practices are much betterdesigned and do not suffer from the inherent instability caused by fundingcrises as repeatedly evidenced in Pakistan.

3.1.3 LIQUIDITYExchange Traded Derivatives not only allow investors to protect their

positions but they also allow them to benefit from various opportunities.Derivatives provide a greater pool of liquidity and encourage investors to enter

the market which makes it more liquid.

3.1.4 LEVERAGEThe initial outlay for derivatives is far less than that required for directinvestment in the underlying security. Derivatives enable investors to benefitfrom a change in the price of the underlying without having to pay its full

price. An investor can therefore purchase a future or an option for less outlayand benefit from the price movement in the underlying asset. The ability toearn a higher return for a smaller initial outlay is called leverage. Investors,however, need to understand that leverage also increases risk.

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3.1.5 SHORT SELLINGDerivatives do not require a rising market to make money. Investors can profitfrom both rising and falling markets depending on the strategy they employ.Strategies may be complex and will have different levels of risk associatedwith each one of them. The flexibility of entering and exiting the market prior

to expiry of options enables an investor to take a view on market movementsand trade accordingly. In addition, the variety of futures and optioncombinations allows investors to develop strategies regardless of marketdirection.

3.1.6 HEDGINGInvestors can buy put options to protect downward risk in underlying or sellcall options (write calls) to generate income. As a writer of options, theinvestor will receive the premium amount up front but will be required to paymargin or lodge the underlying shares as security. The risk is that an ETD

contract can be exercised and the writer would be required to deliverunderlying asset to a buyer at the contract price.

3.1.7 RETAINING THE INVESTOROur world is a big global village. Todays successful businesses fulfill marketneeds across national borders. Similarly, many international exchanges arefacilitating corporations and investors by providing them with services andinvestment tools which are not available to them locally. Numerous Chinesecompanies are currently listing themselves on American and Europeanexchanges.

Perhaps the greatest incentive for introducing ETDs in Pakistan is that wewill keep our investors interested in local markets rather than looking towardsother markets where they may discover greater opportunities for productdiversity and leverage finance. This was a principal motivation for rapidintroduction and subsequent stellar growth of the Indian derivatives industryover the last five years.

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3.2. MARKET INFRASTRUCTUREThe current market infrastructure is as follows:

Figure 5 - Current Market Infrastructure

As depicted above, the current clearing process at NCCL does not involve Novation8of contracts. Proper risk management and capital adequacy of clearing participantsand the clearinghouse is of the utmost importance. Without a central counterparty andconcept of novation, counterparty credit risk cannot be eliminated. Developedmarkets have thrived and prospered because their clearinghouses have beenadequately capitalized and have never defaulted.

As compared to recent developments in other jurisdictions noted above, the Pakistanicapital market is still developing. However, if firm initiatives are taken promptly,such a state of affairs need not be unduly alarming. A recent Bank of England

research paper on mitigation of market risks points out that as nascent marketsdevelop, the requisite infrastructure can be conveniently superimposed over existingstructures.

8 Legal transference of counterparty risks in any trade to the Clearinghouse, i.e., the Clearinghouse becomes thebuyer to every Seller and the Seller to every Buyer in an Exchange transaction.

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Figure 6 - Proposed Model of the Market9

A sound market infrastructure is, therefore, necessary for exchange traded derivativesto start off on healthy footings.

Following is a table that identifies what is required for a sound market infrastructureat Macro level the exchange and clearinghouse. It also identifies the requirements atmicro level for the intermediaries.

9 Possible Model of the Market, International Securities Consultants Limited, March 2005 Report onEstablishment of Organized Derivatives Market in Pakistan.

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Table 3 - Requirements of a Market Infrastructure

Macro / Exchange

Governance Structureo Ownership structureo Elimination of conflict of interesto Rules designed in public interesto Not detrimental to the public interest

Capital Adequacyo Business Plano Growtho Infrastructure

Systems (Trading & Risk Management)o Certifiedo Track Record

Market Surveillanceo Independent

Funds in protectiono Investors protection fundo Settlement Guarantee Fund

Use of independent clearinghouse Management

o Quality / Capacityo Independent

Regulatory Audito Systemso Complaints

Open membership

Integrity Independent compliance for market

surveillance (centralized)

Ongoing compliance and regulatory audit(pre-facto and post-facto elements)

Intermediary

Licensedo Traderso Research analystso Investment advisors

System / trading / Risk adequacy / Riskmargin / Settlemento Requirement should be there for back

office system

Capacity Requiremento You will need to be able to show capacity

to be able to handle

Person who executes the order should knowthe business

Suitability Test Independent body to grandfather Future

Act licensing should be done

Submission of business plan (better qualifiedand better capitalized) at the minimum

Initial Margin Infrastructure Minimum capital requirements (working

capital requirements)

Client agreement & risk disclosure

3.3. LEGAL INFRASTRUCTUREWhereas single stock futures are being traded at KSE, it would be preferable iflegislation is enacted to explicitly recognize derivatives as legal financial contractsenforceable in Pakistani courts of law. In addition it is imperative that SECP and theexchanges have legislative cover to effectively regulate the market and its participantse.g. legislation to cover investor protection funds, clearinghouse claims to have

precedence in case of insolvency proceedings, etc. We understand that such anexercise is underway through proposed legislation of a Futures Trading Act and a newSecurities Act.

3.3.1. LEGAL RISKLegal risk arises from uncertainty due to the potential for legal actions oruncertainty in the applicability or interpretation of contracts, laws orregulations. Therefore, Legal framework for derivatives transactions would

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have to be strengthened with regard to such subjects as the structure andfunctions of a clearinghouse, novation of contracts, their netting procedures,rules for identifying and obviating defaults, etc.

3.4. EXCHANGE STRUCTUREThe structure of derivative exchanges should be able to sustain and strike a balance

between regulatory and business promotion functions in an orderly market. The SECPshould allow for an open licensing regime but foremost it must ensure that there is astringent qualifying process while keeping the needs of the capital market. An entitywishing to carry out the business of a derivative exchange should fulfill the followingcriteria:

3.4.1. FIT AND PROPERThe sponsors of an exchange must demonstrate that they have the experience,technical skills and financial standing to qualify. Their individual interestsshould not conflict with those of the exchange. A broad based ownershipstructure is recommended with a threshold limit on individual ownership byany entity unless specifically condoned by SECP for cogent logic (forinstance, sponsorship by an international exchange that provides much neededknow-how and technology).

3.4.2. FINANCIAL CAPITAL STRUCTUREA derivatives exchange should be adequately capitalized with a minimum

threshold determined by the regulator. Further the capital should be adequatefor both regulatory as well as for business development needs. It should bemandatory for a new exchange to present a business plan with its licenseapplication. While ensuring adequacy of capital, SECP should also ensure thatcontrol of an exchange is not detrimental to public interest.

3.4.3. GOVERNANCE STRUCTUREIt is important that an exchange operates for the benefit of all stakeholders andaddresses all issues of conflict of interest. For a derivatives exchange tooperate efficiently, therefore, the following aspects should be effectivelyaddressed:

Rule makingShould not detrimental to public interest

Separation of Management and OwnershipThere must be clear demarcation in decision making so that marketintermediaries and other stakeholders do not adversely impact rule making andother governance aspects of the exchange. In essence even if an exchange isnot demutualized it must demonstrate the attributes of a demutualized

exchange.

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Conflict of InterestIn a mutual exchange structure, there should be no conflict of interest betweenan exchange and its members in their role as owners including arbitration ofdisputes, etc. A demutualized exchange should ensure adequate safeguards inthe case of self listing. Also, when pursuing business growth, an exchangemust always ensure that its regulatory function is not compromised.

Follow RegulationThe exchange must adhere to its constitution and documented rules of

business without ad-hoc deviation of any sort to ensure that the integrity of themarket is not compromised.

3.4.4. EXCHANGE INFRASTRUCTUREGiven the higher quantum of risk associated with derivative products, prior tocommencement of trading, infrastructure of a derivative exchange, should by

and large be in accordance with international best practices. Adequacy ofsystems at all levels (the exchange, clearinghouse and the intermediaries) isvital for fast execution of trades. Internationally acceptable and tested systemsfor trading, clearing, and risk management, which are all readily available,should be accessed and appropriately deployed by all prospective derivativeexchanges.

3.4.5. RISKMANAGEMENTA risk management structure and its process are both critical aspects of anexchange. These must be dynamic, transparent, and efficient and should at all

times ensure integrity of the market. Additionally, a dynamic risk managementsystem must continuously evolve with developments in international markets.It must respond to changes in perceived risk levels in the market in a dynamicfashion without resort to manual intervention or superimposed rule changeswhich affect market participants. In essence, an automated process of riskidentification, assessment, management and control must be in place at alltimes. International examples of such systems are VaR, SPAN and TIMS10.Finally, an exchange must maintain international standards of adequate andtimely disclosure to all stakeholders.

3.4.6. MARKETABUSE &INDEPENDENT MARKET SURVEILLANCEEach exchange must have independent and automated, real-time marketsurveillance systems which enables it to identify market abuses. Its marketintegrity rules should clearly identify these market abuses. Their occurrenceshould result in timely disclosure, investigation, corrective action and, ifnecessary, penal levies.

3.4.7. NON-DISCLOSURE OF PRICE SENSITIVE INFORMATIONA derivatives exchange must ensure at all times that market sensitive

information within its domain, including but not restricted to, market

10 Refer glossary for description of these acronyms

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surveillance, risk management, clearing etc. remains strictly confidential andis not selectively or otherwise disclosed to unauthorized person/s.

3.4.8. FUNDS IN PROTECTIONAdequate funds should be available from inception to ensure credibleregulatory functions. These funds should be readily identifiable and ring-fenced from other assets of the exchange or clearinghouse through an ad-hoclegal entity. Pre-defined processes should be laid down and followed fordisbursement from these funds. To cater for rising levels of settlementvolumes or other contingencies, a top-up mechanism should also be in place toensure that these funds are always adequately maintained. It is envisaged thatat a minimum the following two funds need to exist:

Investor Protection FundShould have a clearly defined business volume based funding process.

Settlement Guarantee FundThis should be risk based as per the risk management process defined above.

3.4.9. CLEARINGHOUSEPlease refer below.

3.4.10. MANAGEMENT STRUCTURE:An organizational structure should exist with clearly defined roles,

responsibilities, and accountability ranging from the Board of Directors andChief Executive Officer down to various departments of the exchange. Theorganizational structure must demonstrate the following: Capacity head count Quality qualification and experience Independence no conflict of interest Committees As per IBP, including audit, surveillance, business

management, regulatory, etc.

3.4.11. COMPLIANCEIndependent Compliance OfficerA compliance officer, independent of the management, and reporting directlyto the Board, should check compliance with internal policies, rules,regulations, and legislation.

Regulatory audit (post fact)There should be a mandatory annual regulatory audit to ensure that aderivative exchange is acting in compliance with its documented policies and

procedures. The exchange should have capacity to arrange audits of itsmembership on a regular basis.

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3.4.12. OPENTRADING RIGHTSTrading rights should not be restricted to membership. When awarding alicense, the onus should be on the exchange to demonstrate that an applicant isfully qualified.

3.5. CLEARINGHOUSE STRUCTUREIn Pakistan, National Clearing Company Pakistan Limited (NCCPL), which is thesole clearinghouse for domestic equity trade, does not act as a central counterparty(CCP). However, the best international model of clearing is where the clearinghouse

provides guarantee of contracts, clearance and settlement of trades, and managementof risk for their members and associated exchanges. Clearinghouses preventcounterparty defaults by standardizing and simplifying transactions betweencounterparties and themselves.

3.5.1. INDEPENDENT AND CENTRALIZEDClearinghouses can be organized in a wide variety of forms: some areorganized as departments of their affiliated exchanges (vertically integrated)while others are independent legal entities. Some clearinghouses provideservices to only one exchange while others serve several exchangessimultaneously. Some clearinghouses are owned by their member clearingfirms while others are owned by exchanges or are public corporations.Whatever the structure, the clearinghouse should be well capitalized andadequately structured to independently settle all open positions.

3.5.2. CAPITALADEQUACY OF THE CLEARINGHOUSEThe availability of adequate risk capital to ensure credibility of theclearinghouse for settling all trades is paramount.

3.5.3. FINANCIAL SAFETY AND INTEGRITYTo protect itself from counterparty default, the clearinghouse requires margin /collateral from traders in the form of cash, bank letters of credit, or short-termgovernment Treasury bills. Another safeguard employed by the clearinghouse

is the daily settlement process which is called marking-to-market andinvolves deducting losses or adding gains to a traders account, daily. If themargin balance in a traders account falls below a certain threshold referred toas the maintenance margin, the trader will be asked to deposit more money(variation margin) before trading.

3.5.4. CENTRAL COUNTERPARTY(CCP)Most important, with a few exceptions, clearinghouses internationally serve ascentral counterparty to deals struck between exchange members. Through a

process of novation a clearinghouse takes the opposite side of each trade (by

becoming a buyer to every seller and a seller to every buyer). This allowstraders to enter the market knowing that they will be able to reverse their

positions at will.

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3.5.5. CLEARINGHOUSE RISK AND RISKMANAGEMENT STRATEGIESIn most jurisdictions, a risk based margining system is the corner stone of aclearinghouse infrastructure. A CCP acting as the counterparty to tradesassumes a variety of risks including the risk of default by clearing members,the risk of settlement bank failures, the risk of loss of investment funds,operational risks, and legal risks. Each risk is detailed below along with therisk management strategy employed by clearinghouses to address each type ofrisk:

Replacement Cost RiskIf a clearing member were to default a clearinghouse would face replacementcost exposure because the members default does not relieve the clearinghouseof its obligation to the clearing member on the other side of the contract. Theclearinghouse would generally replace the contracts by going into the market

and purchasing or selling contracts identical to those on which the clearingmember defaulted. The risk of loss incurred in this process is the replacementcost risk.11

Liquidity RisksBy substituting itself as counterparty to its clearing members, theclearinghouse exposes itself to liquidity risk: it must fulfill its paymentobligations to non-defaulting members on schedule, even if one or moremembers default.12

Delivery RisksPrincipal risks may also exist if contracts provide for delivery (rather than cashsettlement) and if a delivery-versus-payment mechanism is not utilized toeffect deliveries.13

Risk mitigants

Clearinghouses address the credit and liquidity risks that arise on account ofclearing member defaults by employing the following types of safeguard: (1)membership requirements; (2) margin requirements; (3) default proceduresthat emphasize prompt resolution; (4) maintenance of supplementalclearinghouse resources (5) settlement guarantee fund and (6) an insurance

policy to cover worst case losses in excess of a threshold amount.Clearinghouses also specify limits on the maximum size of positions held byany one clearing member in relation to its capital as an important riskmanagement tool.

Settlement bank failuresIn those cases in which clearinghouses utilize private settlement banks ratherthan central banks to effect money settlements, another source of risk is the

possibility of failure of a settlement bank.

11, 12 & 13 Source: BIS, Clearing arrangement for exchange traded derivatives, March 1997

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Risk mitigants

Among the approaches that clearinghouses employ to manage credit risks andliquidity risks from the failure of a private settlement bank are: (1) theestablishment of strict criteria for the choice of settlement banks; (2) the use ofmultiple settlement banks; (3) the use of other procedures that minimize theamounts and the duration of exposures to settlement banks; and (4) themaintenance of clearinghouse financial resources to cover any losses orliquidity pressures that might result from a failure.

Risk of loss of Investment funds The financial resources that clearinghouses maintain to help cover losses andensure timely settlements are typically invested and therefore face credit,liquidity and custody risks.

Risk mitigants

To protect their investment portfolios from the risk of loss, clearinghousesestablish standards for the creditworthiness of obligors and restrictinvestments to liquid and short-term instruments such as bank deposits andgovernment treasury bills. Even their bank deposits are spread among multiple

banks to further reduce risks. Often, to mitigate liquidity risk clearinghouseshave lines of credit available with commercial banks for use in case ofemergency disbursement of funds.

Operational risksOperational Risk is the risk of credit losses or liquidity pressures that emergeson account of inadequate systems and controls, human error or management

failure.

Risk mitigants

As a safeguard, clearinghouses regularly review the operational risk andstrengthen controls to minimize this risk. As a part of business continuity planand disaster recovery plan, clearinghouses maintain off-site centers where dataare stored and to which processing can be shifted within a few hours.Redundant power sources and communication lines are also commonsafeguards.

Legal risksLegal riskis the risk of non-enforceability of a contract due to reasons such aschallenge against netting, validity of contract, guarantee enforceability etc.have the potential to substantially increase losses from a default, either by aclearing member or by a settlement bank.

Risk mitigants

In most jurisdictions, legally enforceable agreements and contracts areprotected through legislation.

3.6. INTERMEDIARIESThe inherent risk in the derivative products due to the leverage and volatility offered

by these instruments can seriously jeopardize the risk management systems of any

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market. As a first line of defense this creates a requirement for the intermediaries to be adequately structured and capitalized with the right resources to undertake this particular line of business. In accordance with international best practices followingrecommendations are made:

3.6.1. THE NEED FORLICENSING Access by intermediaries to the market should be governed by adequate

licensing to ensure that intermediaries understand characteristics of ETDs.

The regulator should address the minimum entry standards for the variouscategories of intermediaries, capital and prudential requirements; ongoingsupervision and discipline of entrants; and the consequences of default andfinancial failure.

Where licensing is the responsibility of the exchange, it should be subjectto appropriate oversight by the apex regulator.

The licensing authority should also have the power to suspend or withdrawthe license whenever the entry conditions are not (any longer) fulfilled.

All brokers and agents are already required to register with their respectiveexchange and the SECP in order to undertake any business. After thecommencement of a derivatives exchange, intermediaries wishing tofacilitate their clients to deal in the derivatives markets will have to qualifyagainst stringent standards for derivatives trading. New brokerage firmswould be required to adhere to the new requirements. However; existing

brokerage firms should be given adequate notice and time for compliance

with new regulations.

Existing brokerage firms should be given a timeline to update theirsystems and fulfill all requirements to participate in the business ofderivatives. This is necessary to achieve the greater objective i.e.functionalities in the interest of the public.

3.6.2. BUSINESS PLANIn accordance with IBP a formal business plan should be required to be

submitted to the licensing authority. This requires that a business documentsits vision and action plan. This process would require the preparer to actuallycarry out research and communicate the way the business, risks, and financialand other resources are going to be managed. It should be mandatory for anew brokerage firm to present a business plan with the license application.The front line and the apex regulator will know the capability of the brokerand if there are any limitations on part of the broker they can be addressed

before sanctioning commencement of business.

3.6.3. MINIMUM CAPITAL REQUIREMENTSAn intermediary must maintain adequate financial resources to meet its

business commitments and withstand the risks to which its business is subject,such commitments and risks should be mentioned in the business plan as well

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business, communicating with clients, maintaining client records, handlingcomplaints and minimizing conflicts of interest etc.,

3.6.8. COMPLIANCEIntermediaries should have effective policies and procedures in place forcomplying with laws, statutory and self-regulatory obligations as well as withinternational standards of business conduct.

An intermediary should comply with any relevant laws, statutory regulationsand self-regulatory obligations as well as with international standards or codesof business conduct. To that end, intermediary firms need to have in placeeffective internal policies and procedures for supervision and control. Anindependent compliance officer should report directly to the Board and checkcompliance with internal policies, rules, regulations, and legislation.

3.7. INVESTORPROTECTION3.7.1. ACCOUNT MAINTENANCE AND DOCUMENTATIONBroker/dealers should be required to maintain a complete, accurate and up todate record of client transactions and holdings. In addition to maintaining salesrecords by customer account, they must also keep a file of transactionsalphabetically by security. All client records, which must be kept current,should be subject to surprise inspections by a supervisor of the firm or by anyregulatory agency (such as SECP). Minimum time period should be laid downin the law for which the broker should be responsible to maintain and keep all

client records.

Each customer account record must contain sufficient current informationupon which suitability determinations about their investment objective can bemade. Appropriate notation should be present in case these objectives changeor the client wishes to place a certain proportion of funds in securities or

products with an investment objective which differs from that which wasoriginally stated.

To ensure compliance, all mail, offering documents, order tickets, duplicateconfirmations, subscription papers, due diligence files, etc. should be

maintained in a central location and all paperwork should flow through asupervisory chain created to hold specific individuals responsible for ensuringthat all recordkeeping requirements are complied with. Moreover, clientsshould be sent periodical statements and transaction confirmations.

3.7.2. CLIENT PROFILEKnow Your ClientAn intermediary should obtain each customer information about eachcustomers financial situation, investment experience and investmentobjectives (know your client), so as to make suitable recommendations.Every intermediary must try to maintain full, accurate and up-to-date recordsfor all customers providing information about their resources, risk toleranceand financial standing, knowledge of securities and every transaction carried

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out by the firm, the customers positions in securities, and copies of theexchange of letters, or other agreement, between the firm and customers.

3.7.3. SEGREGATION OF CLIENTSASSETSSecurity and protection of clients assets is extremely important. Just asimportant is its segregation. There should be no commingling of clients assetswith those of the firm or with those of other clients. Proper classificationshould be undertaken and proper records should be maintained.

3.7.4. CENTRALIZED DATABASE OF DEFAULTERSInvestors protection is extremely important. But, so is broker-protection. Indeveloped markets all records are kept and credit of individuals andcorporations can be readily checked. In the US there are various agencies thatkeep and maintain credit information and provide scores indicating credit

worthiness. This enables individuals and organizations to judge theappropriateness of any credit extension.

No society is free of fraudulent or manipulative practices. But we can alwayslearn from past experience and from the experience of other markets. Clientsoften take advantage of margin-financing extended to them by their brokeragefirms. But, once they experience significant losses, they resort to default. Inthe absence of a defaulters list such clients move their accounts from brokerto broker and carry out such manipulative practices elsewhere. A centralizeddatabase of defaulters should therefore be maintained to protect broker-interest.

3.7.5. UNIQUE CLIENT IDThe concept of a Unique Client ID was recommended by an earliercommittee appointed by SECP. A Unique Client ID would enable theregulator and the exchange to monitor activity down to client level. Thus allsorts of abuses can be prevented.

3.8. EDUCATION3.8.1. BROKEREDUCATIONEducation of the staff and management of intermediaries should be inline withinternational best practices. Proper education is an important defense to dealwith systemic risk. The following recommendations are made.

3.8.2. COURSES &EXAMINATIONThe SECP, in collaboration with the brokerage industry, should sanction

professional preparation of various types of requisite course outlines for ETD.Once these are finalized to the satisfaction of the regulator, exchange and

brokerage firms, education in them can be outsourced to colleges, universities

and/ or specialized institutions. This will expedite infusion of professionalisminto the capital market and boost confidence of future investors in thederivatives market.

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3.9.2. CATEGORIZATION OF USERSUsers of derivatives, whether exchange-traded or OTC may be broadlycategorized into three groups:

Hedgers

Hedgers are typically agri-producers, manufacturing businesses and financialinstitutions who buy and sell futures contracts seeking to lock in future prices for commodities or securities that are essential to their businessoperations.

SpeculatorsSpeculators are a diverse group that includes day traders, financial institutionssuch as banks and commodity / securities hedge funds. Traders decisionsgenerally arent random, but are based on a synthesis of a great deal of dataand a variety of different strategies. Some people make trading decisions

based on fundamental analysis of the forces of supply and demand in a

commodity market while others base their trades on technical analysis ofmarket trends and price chart patterns.

ArbitragersThese are usually professional individuals and ad hoc

traded deri

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