Key developments happened with regards to currency options, physically settled derivatives and credit default swaps.

To supplement its rapidly growing foreign exchange futures market, the Reserve Bank of India has approved the introduction of currency options. On July 30, the RBI said it would permit trading of currency options on the spot US dollar-rupee rate in the currency derivatives segment of stock exchanges recognised by the Securities and Exchange Board of India.

India’s two leading financial derivatives exchanges, the National Stock Exchange of India and the MCX Stock Exchange, owned by the Multi Commodity Exchange of India, are locked in a fierce fight for market share in FX futures – and it appears round two is about to start.

Hurry up, says court

In the latest turn of events, the Bombay High Court has stepped in, giving the Securities and Exchange Board of India until September 30 to decide whether to approve the MCX Stock Exchange’s application to expand into equity and interest rate derivatives, cash equities and bonds.

MCX SX had taken legal action against the SEBI in July, claiming that the regulator’s delay in granting approval was unfair and was costing the exchange substantial amounts of money.

While NSE has been able to cut fees for FX futures, living off the proceeds of its other businesses, MCX SX is only allowed to offer one product, so has had to lose money to stay competitive in FX.

MCX SX asked for permission in June 2009 to offer futures on 10 year Indian government bonds, and later developed plans for equity derivatives, shares and bonds.

Ravi Kadam, the exchange’s lawyer, said SEBI had failed to respond to letters seeking clarification about the delay.

MCX begins mock trading

On August 2 MCX SX began mock trading of currency options in readiness for SEBI’s approval. A source at the NSE also confirmed that it would apply to the SEBI to offer FX options.

Meanwhile, the Bombay Stock Exchange has entered a partnership with the Options Industry Council, to educate Indian market participants on the value of options trading.

The BSE previously competed with the NSE and MCX SX in FX futures, but has given up and delisted its contracts, after acquiring a stake in the soon-to-be launched United Stock Exchange of India. Expected to launch in the coming weeks, USE aims to rival the NSE and MCX SX in FX futures and options trading.

Physical comes closer

In July, SEBI confirmed that exchanges would be allowed to offer physically settled equity derivatives, though it stopped short of announcing the delivery mechanism.

At the moment the BSE and NSE both offer cash-settled equity futures and options.

SEBI said that if either of them wanted to offer physically settled contracts, it would require “a detailed framework for implementation of physical settlement of stock derivatives”.

“Stock exchanges may introduce the new system in a phased manner, but initially, all physical settlements for stock options and stock futures must be completed within six months,” SEBI said.

Spokespeople for BSE and NSE were non-committal on whether each would try to list the new products.

However, Sam Basha, head of derivatives at HSBC India, said he expected them to do so. He added that while SEBI appeared to have put the ball in the exchanges’ court, the regulator usually also instructed the exchanges on specifications for new contracts, and he expected the watchdog to lead the way in designing the delivery mechanism.

RBI outlines CDS policy

In a step towards permitting credit default swaps, RBI has published a draft operational framework for the market. The bank said in March that it was “revisiting” its draft policy towards CDS, first issued in 2007 but put on hold because of the global financial crisis.

On August 4, it set out a policy for introducing plain vanilla, OTC single name credit derivatives referencing corporate bonds issued by Indian-resident entities.

Tight restrictions will govern trading. However, the RBI said: “keeping in view the need for development of the infrastructure sector, CDS shall be permitted to be written on corporate bonds issued by special purpose vehicles of rated infrastructure companies.”

Firms eligible to trade CDS are divided into two subsets, market makers and end users – the group with the greatest regulatory restrictions.

End users may include commercial banks, primary dealers, non-bank financial companies, mutual funds, insurance companies, housing finance companies, provident funds and listed companies. They can only use CDS to hedge existing credit exposure, and the protection can be bought only: “to the extent (both in terms of quantum and tenor) of such underlying risk”. Settlement for end users must be physical.

Market makers may include commercial banks, non-bank financial companies, primary dealers, insurance companies and mutual funds. These firms may buy and sell protection, subject to unspecified eligibility criteria. They can choose between physical, cash or auction settlement, provided the CDS documentation envisages such settlement.

RBI is anxious that “appropriate safeguards” should surround the market. The central bank will set regulatory standards but said market participants must also “take these risks into account and build robust and appropriate risk management system to manage such risks.”