Derivatives

Exchange Traded Derivatives are those derivatives which are traded through
specialized derivative exchanges whereas
Over the Counter Derivatives are those which are privately traded between
two parties and involves no exchange or intermediary. Swaps, Options and
Forward Contracts are traded in Over the Counter Derivatives Market or
OTC market.
Introduction
The Derivatives Market
Derivatives or derivative contracts form a significant volume of trading on
almost every major global market around the world today. While some
simpler forms of Derivatives have remained available over the last hundred
years the advent of the computer and the world wide web along with the
development of new mathematical tools has permitted the development and
use of newer and more profitable derivatives in the last decade resulting in
the extensive use of Derivatives and their trading in larger and larger sums
and quantities[1].
The following is a table of the volume of Equity based Derivatives traded
world wide from 2000 to 2002[2].
This volume has only increased in the last two years. In India according to
recent statistics, The average daily volume traded in the derivatives
segment is approximately Rs. 1100 Crore[3].
However, with an increased volume of derivative trading across the world
have come increased risks of loss to speculators and institutional investors.
Perhaps most prominently featuring in the media is the failure of the 233-
year-old British investment bank Barings PLC which declared itself insolvent
in February 1995 as a result of $ 1.5 billion losses resulting from an
investment by a twenty-seven-year-old futures traders invested on index
futures in the Nikkei 225 stock index[4].
One of the largest loss to date occurred in December 6, 1994, where Orange
County, California lost over $ 2 billion dollars in estimated losses as a result
of derivative transactions[5]. Another major loss in the derivatives market is
that of Metallgesellschaft AG, the German engineering and metals
conglomerate who lost nearly $ 1.4 billion attempting to hedge with oil
futures[6].
Other major investment houses and investors to lose money include Merrill
Lynch who lost $ 377 million on one unhedged position in mortgage-backed
securities in 1987, Salomon Brothers who lost $ 250 million betting on the
yield curve over a two-month period in1992. Bankers Trust created $ 39
million in non-performing assets in a single interest rate swap, J.P.
Morgans, Proctor & Gamble Co. and Gibson Greeting Inc., George Soros and
David Askin who have all lost more than $ 100 million on trading
Derivatives[7].
Thus it is increasingly clear that there exists a clear and well defined need
for regulation of the Derivatives Market. It is also clear that there exist
pitfalls and traps in the process of Derivatives trading which entrap even
professional and institutional investors. It also becomes clear that there is a
need for regulation of Derivative transactions, and definitional clarity about
the term Derivatives and the various forms of instruments that are counted
as Derivatives.

Research Methodology
Aims and Objectives :
The following Aims and Objectives have been identified for this paper.
To examine and understand Derivatives and how they are classified.
To examine in detail the functions of Derivatives and in particular the
functions of Single Stock Futures.
To examine the Badla System in India.
To compare and contrast the Badla System and Single Stock Futures and
make arguments against the abolition of the latter in favour or the former.
Scope and Focus:
The scope of this paper has been restricted to the examination of the Badla
System in contrast with Single Stock Futures. All other aspects of
Derivatives and The Indian Capital Market, have been dealt with briefly only
for the purposes of understanding.
.
Limitations:
In the interests of Brevity and Focus, the paper has been narrowly restricted
to making an argument on the above issue and the authorities cited have
been selected as such.
Style of Writing and Mode of Citation:
An Comparative and Analytical style of writing has been adopted through
the paper. A uniform mode of citation has been followed.
Hypothesis
This paper is based on the following hypothesis :
The Badla System in India offers advantages which the Single Stock Future
cannot provide to the investor and should not have been abolished on
introduction of the former.

What are Derivatives?
The term Derivative, while in common use as a proper noun, is in fact an
Adjective. This interesting usage arises from a common feature of all the
types of instruments which are termed Derivatives. For this reason,
Derivative securities are also termed contingent claims [8].
All Derivatives have no inherent value but derive their value from the
value of some other asset be it a specific stock, commodity, stock index,
interest rate, or exchange rate. This asset is called the underlying, a word
which is again an adjective and not a noun. The underlying can thus be
defined as simply the rate, index, or price upon which the derivatives value
is based [9]. For the purposes of this paper we will consider only Derivatives
whose values derives from stocks and stock indices.
In India, two Committees have examined the definition of Derivatives and
have come to similar conclusions. The latter of these, The Dhanuka
Committee on securities regulation, defines a Derivative thus,
Derivatives includes a contract which derives its value from the prices of or
index of prices of underlying securities, the settlement of which shall be
carried out in such manner as may be specified.[10]
Thus a derivative instrument is essentially a financial contract whose value
is not inherent but is derived from, the level of some agreed-upon
benchmark[11] .
Usually this instrument is in form of a contract that allows or obligates one
of the parties to it to buy or sell an asset[12]. The value of such contract
thus mimics the movements in the value of the underlying asset. Indeed, the
contracts defining characteristic is that its value derives from the value of
the underlying,
The value of derivatives can be based on stocks, bonds, commodities,
currencies, government or corporate debt, home mortgages, interest rates,
exchange rates, indexes that reflect the value of some bundle of financial
products, or any combination of these. For the purposes of this paper we
will be examining derivatives whose underlying is a specific stock or a
stock index.


Types Of Derivatives
Derivatives are classified in several ways. One classification divides them
into two types based on the way they are contracted. Derivative contracts
entered into through organized exchanges are termed Exchange Traded
Derivatives. An individual can purchase such Derivatives through his stock
broker like he purchases shares. He need not need not worry about who is
on the other side of the transaction. These transactions are regulated by the
exchanges on which such contracts are entered into.
The other type of derivative transaction[13] involves one time special
contracts entered into between individuals. These contracts are termed OTC
derivatives. Very often these Derivatives are not subject to any form of
regulation and remain valid as long as such they do not violate any of the
various provisions of the Contract Act or the Securities Contract Regulation
Act. These two types of derivatives offer different advantages as far as the
person entering into the transaction is concerned. The first offers greater
convenience and security, while the OTC offers higher degrees of
customization and greater transacting freedom. The advantages of the OTC
sector come along with a large risk of losses due to default. Consequently,
the OTC category is dealt in largely by institutional investors. Like the
exchange traded segment the OTC derivatives market too has enjoyed
enormous growth . On a crude, notional amount basis the market for
selected OTC derivatives reached four trillion dollars by year-end 1991, eight
times its level five years before[14].
For the purposes of this paper we will examine exchange traded derivatives
in greater detail.
Derivatives are also classified according to the nature of the underlying into
Financial Derivatives and Commodity Derivatives. While the underlying in
case of the latter consists of actual quantities like wheat or pork fat, the
underlying in the former is usually a security, index or rate. For the
purposes of this paper we will be examining only financial derivatives.
A more popular classification of Derivative instruments divides them into
plain vanilla[15] derivatives and hybrids or exotics. The Plain Vanilla
Derivatives usually include Futures, Forwards, Options and Swaps though
the last of these is often not considered a plain vanilla option[16]. We shall
now consider each of these types of instruments in turn.
Options
An option is a contract giving one of the parties to it a right, but not an
obligation, to buy[17] or sell[18] a given asset at a certain price during a set
period of time. Options are available both in exchange traded or OTC
varieties. The person purchasing an option pays a fee or premium for the
contract. This premium is usually calculated as a percentage of the face
value of the underlying. Unless the market value of the underlying asset
exceeds the price fixed by a call option (or is less than the price fixed by a
put option), the end-user has no incentive to exercise the option.
Forwards and Futures
Futures are extremely old financial instruments. Trading in futures
originated from Japan during the 18th century where futures were used in
trading of rice and silk[19]
A forward contract can be regarded as the simplest mode of a derivative
transaction. It is merely an agreement between two or more parties to buy or
sell an asset at a certain time in the future at a certain price. Futures
contracts are special types of forward contracts in the sense that they are
standardized exchange-traded versions of forward contracts.
The major differences between futures and forwards are as follows.
Futures are guaranteed by the clearinghouse of the exchange on which they
are traded. No such guarantees exist in forward contracts.
Since the exchange serves as guarantor of payment, futures contracts
necessarily function through payments of margin profits and margin losses.
Forward contracts do not involve such daily payments.
Futures contracts are standardized in all terms except for the underlying
price of the commodity. Forward contracts are custom made for each
individual client. Consequently, it is very easy to enter or exit into a
position on a futures contract, due to their exchange traded nature. It is
generally very difficult to exit out of a forward agreement because of its
customized terms.
Most importantly, a Forward contract is not entered into for the same
reasons as a Futures contract. A futures contract is rarely if ever carried
through to its ultimate conclusion. A futures contract is usually offset by an
equal and opposite transaction before its expiry date it main and often sole
purpose is hedging or speculation. A Forward contract is usually entered
into for the purposes of fixing the price of a commodity rather than for
purposes of speculation or hedging investments.
Futures may be based on a single stock or on an index.
Swaps
Swaps are a type of forward contract in which two parties agree to exchange
a series of payments according to agreed-upon terms over a set period of
time[20]. The amount of the payments involved is determined with reference
to an agreed-upon notional amount which is seldom actually
exchanged. Because the terms of a swap must be carefully tailored to
benefit the parties needs, this type of derivative instrument is a privately
negotiated, OTC transaction. Swaps are commonly used as hedging devices
by corporations, banks, and other financial institutions[21].
Exotics
Apart from the above Plain Vanilla flavoured derivatives, The market also
offers more exotic flavours of derivatives such as embedded options, reverse
floating rate notes (inverse floaters), and indexed currency option notes
(ICONS). Some more exotically named exotics have names like mambo
combo, strangle, surf and turf, swaption, and death-backed
bonds[22].
For the purposes of this paper we will be examining one plain vanilla
derivative namely the single stock future in greater detail.

Single Stock Futures
Single Stock Futures are instruments have had a Chequered past. While
they are universally recognized as extremely powerful instruments for the
purposes of risk management through hedging, many countries have been
extremely hesitant to permit exchange based trading in them.
In the US, they formed the basis of an regulatory tussle between the
Commodities and Futures Trading Commission and the Securities and
Exchange Commission, as a result of which they were unregulated for a long
time and subsequently banned. They also did not enjoy widespread global
popularity.
Thus, In the early 1999 when the L.C. Gupta Committee Reported on the
feasibility of introducing Derivatives into the Indian Market, it recommended
against the introduction of Single Stock Futures stating that
The fourth type, viz. individual stock futures, was favoured much less. It is
pertinent to note that the U.S.A. does not permit individual stock futures.
Only one or two countries in the world are known to have futures on
individual stocks.[23]
However the scene had changed when SEBI re-examined the Derivatives
Question in 2002. [24], This change has occurred due to several reasons.
Firstly, in 2000, the United States passed the Commodity Futures
Modernization Act that demarcated the jurisdiction of the CFTC and the
SEC and thereby removed the regulatory obstacle to single stock futures[25].
By 2001, the United Kingdom, Greece, Mexico, Canada, Singapore, Hong
Kong, Netherlands, Spain, Australia, Sweden, Finland, Denmark, Portugal,
Hungary and South Africa were all trading derivatives. This prompted the
Committee in 2002 to strongly recommend the introduction of single stock
futures and state that
Advantages Proffered By Single Stock Futures
Single Stock Futures offer unique advantages for the investor, more so than
any other equity based derivative[26]. These advantages are perhaps best
illustrated by comparing the single stock future with its closest competitor,
the single stock option.
The price behavior of the above derivatives is very different. ( i.e. Their
pricing is affected by different factors). While the prices of futures move
more or less in step with the underlying, the prices of options are affected by
volatility (i.e. the likelihood that the option will be exercised).
Apart from pure speculation, the purpose of an option is to provide
insurance against an unwanted price movement, for the cost of a premium.
A Single Stock Future on the other hand provides direct leveraged exposure
to the stock, which can be used to trade the stock short term without
putting up the full price, it also permits the creation of conflicting positions
to offset losses in the market. Thus, unlike an equivalent single stock
option, a SSF offers advantages to speculators and hedgers.
Furthermore, Single Stock Futures are typically cheaper and less cash
intensive than the equivalent option. A trader who is buying a Single Stock
Future has to put a margin, while an option buyer has to pay a premium
and possibly also a margin depending on the requirements of the local stock
exchange.
Therefore, Single Stock Futures appeal to speculators looking for quick,
cheap and direct exposure to the market in an individual stock. They are
essentially substitutes for the cash market.

The Functions of Derivatives
The Raison dtre for the existence of Derivatives is Risk and Risk
Management. Over the last three decades Risk has evolved from a quantity
that was uniformly hated and generally considered unpredictable to a
quantity which is classified, predicted, controlled and in some quarters,
even welcomed. In fact Risk is considered as a source of income to those
who can manage it.
Alan Greenspan, Chairman of the US Federal Reserve has, describing the
expansion of derivatives usage as the most significant financial event of the
last decade, stated that
These instruments enhance the ability to differentiate risk and allocate it to
those investors most able and willing to take it a process that has
undoubtedly improved national productivity growth and standards of living.
[27]
In fact the pivotal event which provided the boost for the rapid expansion of
the Derivatives Market was the publication of a paper detailing by Fisher
Black and Myron Scholes detailing their new Black- Scholes option pricing
model[28]. This new model combined with the power of computer tools
permitted risks associated with derivatives to be calculated and distributed
with far greater accuracy. As one author puts it
The theoretical foundation for the pricing, risk assessment, and hedging of
a broad spectrum derivatives had been laid. The modern derivatives
industry had become possible.[29]
Now as then the function of Derivatives is to improve efficiency by breaking
apart risk and parcelling it out to the parties who are the cheapest and most
willing risk-bearers[30]
Keeping this in mind, three clear uses for derivatives can be found, each of
which is used by three different types of investors. These investors differ in
their affinity towards risk.
Hedging Transactions
Derivatives are used for hedging by risk averse investors who wish to
eliminate all or some risks involved in their business transactions.
Take for example an Indian Manufacturer who receives a component worth
$ 1000000 which has to be paid in two months. He incurs a risk of the US
Dollar appreciating against the Indian Rupee in the next two months as a
result of which he will have to effectively pay a larger amount in two months
than he does now. This is termed a currency risk.
Now in order to counter this risk he can purchase currency futures worth
1000000 Dollars. If the Dollar does appreciate significantly, he can offset his
gains in the futures market against his losses in his normal business
transaction. If the Dollar does not appreciate as such he can offset his
losses in the futures market against his gains in his transaction. Thus his
losses are hedged in any eventuality.
An investor is not uniformly risk averse or risk friendly. For example an
investor may be confident that the company he is investing in has good
fundamentals, and yet may not be confident about the general market trend.
Thus he is willing to incur a Fundament Risk and not willing to chance a
Market Risk. Derivatives are flexible enough to cover the expectations of
such investor as well.
The solution for such an investor will be to purchase the stocks he favours
and attempt to make a profit by incurring a fundamental risk while
negating the market risk by purchasing index futures which will offset any
gains or losses suffered by the market. In fact the investor can garner more
of a profit by incurring more of a Fundamental Risk by purchasing single
stock futures in the company he favours instead of buying stocks.
Speculative Transactions
Speculation, like risk was a bad word for most investment regulators till not
long ago. However, it is well recognized today that risk friendly
speculators can potentially generate the most income in, and form an
essential part of, the modern financial market. In the market the Risk
friendly speculator is the other side of the coin to the Risk Averse hedger.
For example, in the previous example a Speculator may be confident that
the market risk involved in the above transaction is negligible. Thus he
purchases short index futures, essentially taking the opposite position from
our risk averse hedger. He does this purely for the purposes of profit, and
not for the purposes of protecting any of his transactions. He essentially
gambles on his assumptions and makes a profit out of his gamble.
Arbitrage Transactions
The Arbitrageur forms the mid point between the Speculator and the
Hedger. Like a Speculator, he enters into a transaction for the purposes of
profit, but like the Hedger he is not willing to incur any major risks. He
survives by taking advantages of market currents and market imperfections.
An ideal example of an arbitrageur using Derivatives is someone who on the
day before a future contract matures, purchases a single stock future priced
at Rs. 100 and uses it to buy a stock worth Rs. 101. The most well known
type of version of the arbitrageur is the Day trader who extracts vast
amounts of profit from tiny movements of the market. The key to successful
profit making by an arbitrageurs is the maximum utilization of capital. In
this regard Derivatives offer huge benefits for arbitrageurs.
For example, to take advantage of 1 Rupee movement in a stock worth Rs
100, the arbitrageur will have to invest 10000 Rupees to make a mere Rs
100. However if he purchases a single stock future on the same stock, even
assuming a margin deposit of 10 % he will make a profit of Rs. 1000 for the
same investment. Arbitrage is a powerful force which aids in the process of
price discovery.
Thus it is clear that derivatives offer extremely powerful risk management
tools for the Risk averse and Risk Friendly investor and that the function of
any derivative will remain risk management.
BADLA : THE CARRY FORWARD SYSTEM
The earliest form of Badla was forward trading was carried out in
government securities on their introduction in the early 19th . This lasted
till 1935 when it was banned. Badla in shares started towards the end of the
19th century lasted with few disruptions till June 27, 1969 when it was
banned by the government.
In June 1972, a carry forward was permitted from one 14 day stock trading
cycle to another in certain specified shares. This system however was
plagued by a lack of regulation. Continued demands from market operators
led to the introduction of the Badla system on specified shares in the four
major exchanges in 1983. This system too relied on the fiction of a spot
settlement with carry forward delivery. This system ad a number of
restrictions including limits on daily margins, carry over margins, automatic
margins, limits on individual holding margins, limits on price fluctuations
etc. This system is acknowledged to have increased liquidity tremendously
and improved market conditions[31].
In 1993, the Badla system was banned again following fears of excessive
speculation. This ban continued to be in place till it was revived January 15,
1996 in the guise of the revised carry forward system based on the
recommendations of the G S Patil Committee. This system had several
limitations and restrictions, which were relaxed based on the
recommendations of J R Varma Committee and termed as Modified Carry
Forward System (MCFS). This was replaced with effect from January 22,
2001 by a system called Borrowing and lending Securities Scheme (BLESS).
All systems after 1996 have not found favour with traders because of the
following restrictions which have been imposed on them.
Fixed Margins : Exchanges are required to fix very stiff daily margins to
carry forward transactions. They are also required to mark to market all
gains an losses on a daily basis.
Carry forward is limited to a maximum of 90 days.
Limits on carry forward systems have been imposed in as both percentages
of total transactions as well as on the amount of the total business to be
carried forward by a broker.
Most importantly perhaps the financers were denied contango charges
which has reduced interest in the market by a large margin[32].
The word Badla means something in return in Hindi and Gujarati. It is
used to refer to the system of carrying forward shares[33].
The Carry Forward System : When shares are purchased, a person has
three choices, one of which must be availed within a fixed period of time.
Delivery of the shares may be taken on the settlement date after paying due
consideration.
A share purchase contract may be offset by an equal and opposite sale
agreement which has the same settlement date.
The purchase may be carried forward to the next settlement cycle at the
price on the date of settlement with the difference between the contract price
and the sale price being settled[34].
The Badla system does three things.
Enables an to participate in price variations in stocks without giving or
taking delivery.
Enables an investor to short sell on a particular scrip without owning
shares. This is done through a system of stock lenders who enter the carry
forward system and lends his stock to the investor.
Thirdly, if the investor wishes to buy the share without paying the full
consideration, the Badla financier steps in and provides the finance to fund
the purchase[35].
Take a market where there have been trades of 12 lots of 100 shares each in
Reliance stock. Let us assume that each lot has been bought and sold by
separate persons, thus there are 12 separate buyers and sellers respectively.
Among the buyers six buyers want to take delivery of their stock while six
want to carry forward their positions. Of the sellers eight wish to make a
delivery of their shares while four want to carrying forward their positions.
Crossing out the transaction between the six buyers who the payment for
their purchases, and the six sellers who make delivery, we have four buy
carry-forward positions and four sell carry-forward positions left.
Here the Vyaj Badla financiers come in. They take delivery of the shares
from the sellers in one financial cycle and pass it on to the buyer in the
next. The shares are delivered by the seller and are kept in the clearing-
house and allocated to the financiers broker in a special account, these
form the financiers collateral.
In any Badla transaction there exist two main rates, namely the Hawala rate
and the Badla rate, for each scrip. The Badla charge is the interest payable
by the investor for carrying forward the position. The Badla charge, as
explained earlier, is market determined and primarily dependent on the
supply of funds for financing a share.. The Hawala rate is the price at which
a share is squared up in the current settlement and carried forward into the
next settlement in the next trading session. The existing share position is
squared up against the Hawala rate and carried forward after factoring in
the Badla rate. The difference is paid to the broker or received from him.
For example if 100 shares of Reliance are purchase at Rs. 100 each under
the current settlement and a carry forward to the next settlement is desired.
If the share has appreciated by Rs. 10 per share over the settlement, The
Hawala rate is fixed at Rs.110 and the Badla rate say is fixed at 10 % for the
settlement, which usually used to last a week. In this case, the Badla
charge accrues to the investor. If the hawala rate is lower than the initial
rate, the difference has to be paid to the broker.
In actual practice, a margin is maintained with brokers for arranging Badla
finance. The amount of leverage availed depends on the margin which is
required by the broker
The Badla charge is interest for the financers financial outflow. However, it
must be noted that the financer is merely a lender of money for the
purchase of shares, all the rights and obligations of the share (including
dividends) are passed on to the buyers as soon as delivery is taken by the
Badla Financer. If the buyer offsets his purchase in the next settlement
cycle, he essentially manages to participate in share price variations without
ever having invested the entire share price. His only expenditure in this
regard is the Badla charge.
This is termed a Seedha Badla. An outstanding sell position in the stock
(where someone wants to sell a share he cannot deliver) sees an Ulta or
Undha Badla where stock lenders participate. They lend shares to the
short seller in the current settlement and claim them back in the next. For
this they charge Backwardation charges or Undha Badla charges. This type
of Badla enables a person where a person gets to short sell stock without
paying full consideration for it.
These transactions provide liquidity and flexibility to the market. They
provide a much needed output for financers. Consequently as a result of
this utility, the 2000 the Badla market was estimated at the Rs 4,000 Crore
mark[36].
The Macroeconomic effects of the Badla System
The Badla system has several important macroeconomic effects on the stock
market.
It injects liquidity into the trading system with large orders and enables
large sales and purchases to absorbed without any market disruptions.
,It narrows the gaps between spreads between bids and offers are narrower
in shares having the carry forward facility consequently reducing market
imperfections.
Thirdly, it system helps in reducing volatility by facilitating short sales in a
rising market and long purchases in a declining market.
Fourthly, Badla financing in the carry forward system enables employment
of short-term funds with high returns.
Fifthly, Badla financing allows for effective price discovery.
Finally, the Badla system acts as a very effective risk management
instrument.

Conclusion
Badla trading and Single stock futures : A Comparison
A dissent note in the Varma Committee Report studying the Badla system
and its adaptation to the rolling settlement offered an was the among the
first voices to recommend the replacement of the Badla system with
Derivatives in the form of single stock futures. The note read,
As such, Dr. Patil and Prof. Varma recommend that the weekly carry
forward product should swiftly migrate to a full fledged futures contract in
individual stocks. When this is done, the product will cease to be regulated
as a carry forward product and will be regulated exclusively as a derivatives
contract.
The majority of the committee, preferred the Badla system on the ground
that the market would find that product easier to understand and use.
The developments in the derivative markets during 2000 contributed to the
view that carry forward system may not be easier to understand and use
than single stock futures. The apparently superior risk containment model
for derivatives swayed the thinking of the Committee and led to the
recommendation to abolish carry forward completely and replace it with
single stock futures[37]. This recommendation was also supported by
international pressure to enter the Derivatives market and abandon the
Badla system[38].
Off late many dissenting voices have arisen questioning the validity of such
a ban[39].
Many of these dissenting voices advocate that the Badla system is a better
option for the Indian stock market than anything the derivatives market
can provide.
The researcher is inclined to agree with this opinion for the following
reasons,
The Badla system has been functioning in India for several decades now.
The brokers and exchanges are familiar with its intricacies and are in a
much better position to innovate and analyze Badla transactions to a much
better extent than the less familiar Single Stock Future. Furthermore, there
is bound to be some amount of hesitancy among investors in making use of
a new unfamiliar instrument and this hesitancy may result in funds being
diverted to the illegal market. Thus, the efficiency of the market as a whole
is impaired. This hypothesis is affirmed by two separate sets of trends,
Firstly the observation that Single-stock futures continue to account for a
major proportion of the F&O segment in India accounting for 70 per cent of
the total turnover during June 2002. A primary reason attributed to this
phenomenon is that traders are comfortable with single-stock futures as
they closely resembles the Badla system[40]. Secondly, the trend is
accompanied by rapid increase in illegal Badla trading activities which carry
on in the parallel.
It well recognized that single stock futures do not provide for perfectly
accurate hedging. Indeed it is a common saying in international financial
circles that the only perfect hedge is a Japanese Garden[41]. One of the
major reasons for the inability to hedge perfectly is because of the known
discrepancy between spot prices and future prices. In Badla Transactions
there is difference between delivery, offset and carry forward prices of the
stock. Thus, they can theoretically form the basis of perfect or near perfect
hedges. Furthermore, no payment of premiums is necessary in the Badla
market and the amount of margin payment is offset by the Hawala Rate.
Thus Badla transactions form highly leveraged instruments which can be
used by the speculator and hedger alike[42].
One of the major reasons for the introduction of Derivatives into the market
place is to increase liquidity in stocks. However, it is well recognized that
Badla transactions consistently increased liquidity in transactions where
they were permitted[43].
Perhaps most importantly, there is no either/or choice between Badla
transactions and Derivatives. It is well recognized that futures in individual
stocks can co-exist with the Badla system and that market selection will
discard whichever instruments it finds redundant. Deferral products could
have been allowed to continue so that operators in the market could choose
the product they needed.
Indeed some authorities have questioned the compatibility of the ban on
Badla with the role of a regulator in the market and stated that
The regulating authorities should desist from structuring the market
instruments; they should confine themselves to ensuring transparency and
safety of the operations.[44]
The Division of Market Regulations of the Securities and Exchange
Commission of the US in its monumental study Market 2000 has observed
that
The Divisions believes the Commission best fulfils its statutory mandate
when it concentrates on protecting investors, facilitating fair competition,
and providing full disclosure. The equity markets are too dynamic to
conclude that the government could one and for all establish the ideal way
to trade equities[45].
Indeed, it is clear that there may exist some amount of risk of default in
transactions involving the Badla System since many of these transactions
are not guaranteed by a clearinghouse system, however, it is submitted that
such safeguards may easily put in place much like the various margin
restrictions and bars imposed on Badla Transactions in the past under the
MCFS and ACFS.
It is submitted that the real need as far as the Badla system is concerned is
to put in place proper and effective systems of surveillance and monitoring
along with regulatory systems which ensure transparency and severe
penalties for those jeopardizing the market.
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Derivatives Transactions in the United States, 29 Cornell Intl L.J. 767.
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the Study of Financial Innovation, Paper No 52, February 2002, Downloaded
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by the IIM Calcutta finance club and Downloaded from the IIMCAL website
at www.iimcal.ac.in/community/FinClub/art16-idm.pdf.
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<http://www.investopedia.com/university/futures/futures4.asp>
11. Glenn Whitney & Nicholas Bray, Court Clears Offer for Most Of Barings
PLC, WALL ST. J., Mar. 7, 1995, at A15.
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Informational Failure and the Promise of Regulatory Incrementalism, 102
Yale L.J. 1457, 1464-65 (1993).
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Instruments, 49 SMU L. Rev. 579.
14. Lyle Roberts, Suitability Claims under Rule 10b-5: Are Public Entities
Sophisticated Enough to Use Derivatives, 63 U. Chi. L. Rev. 803.
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Mechanisms, The Financial Express, Thursday, May 31, 2001.
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BOOKS
Fred D. Arditti, Derivatives,
N.D.Vohra et al., Futures and Options, p.215 (Tata Mc Graw Hill : Delhi,
2001).
COMMITTEE REPORTS
The Report of the Securities and Exchange Board of India Commission on
Derivatives, 1998. Downloaded in PDF format from the SEBI Website at
www.sebi.gov.in.
Report on Development and Regulation of Derivative Markets in India, SEBI
Advisory Committee on Derivatives, September 2002. Downloaded in PDF
format from the SEBI Website at www.sebi.gov.in.
The Gupta Committee Report on Derivatives, 1998, Para 1.8 , P.10.
. Downloaded in PDF format from the SEBI Website at www.sebi.gov.in.