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© NCEL Prospective Pakistan Mercantile Exchange Limited December 2006
© NCEL Contents Welcome Risks in Trading Futures Introduction to Futures PMEX Highlights PMEX Business Model How to Trade at PMEX Investor Safeguards Demo
© NCEL Risks in Trading Futures
© NCEL Should You Trade Commodity Futures? Trading commodity futures is not for everyone. It can be a volatile and risky business. Before you invest any money in futures contracts, you should: –Consider your financial experience, goals, and financial resources –Understand commodity futures contracts and your obligations before entering the market –Be aware that you can lose more than your initial investment –Only take risk for the amount that you can afford to lose –Understand your exposure to risk and other aspects of trading by thoroughly reviewing the risk disclosure documents your broker is required to provide you
© NCEL Can I lose Money Trading Futures? Yes, if you are reckless –Lax controls, poor corporate governance, over confidence, hoping to recover through taking an even bigger position, etc. But it is not Rocket Science –Proper Understanding and Respect of Risk can ensure losses are contained and gains are preserved
© NCEL Introduction to Derivatives
© NCEL Who Participates in Futures Markets? Meets the needs of three groups: –Those who wish to discover information about future prices of commodities (suppliers such as farmers) - Natural Longs –Users & intermediaries – Natural Shorts –Those who wish to invest (investors) and have a view – extremely important as they provide liquidity and depth to the market –Investors are essential for the market
© NCEL Futures Perspectives Gains (Losses) for longs are offset by equal losses (gains) for shorts Counterparties in Futures are involved in a zero sum game - for every winner there is an offsetting loser Futures exchanges counter excessive speculation and concentration through position limits Clearinghouse runs a perfectly matched book and does not take positions in the market A common fallacy - high margin mitigates risk
© NCEL What are Derivatives? A derivative can be defined as a contract that derives most of its value from some basic underlying asset: Examples: Futures – a right and an obligation - Commodity, precious metals, single stock, interest rates, stock index, energy, etc. Options – a right but NOT an obligation??? Swaps Etc…
© NCEL What are Futures Contracts? FUTURES – Definition: a contract between a buyer and a seller under which the seller agrees to deliver a specific commodity on a specific future date to the buyer for a predetermined price to be paid on the delivery date – It conveys an “Obligation” Price is negotiated at the time of execution of a trade on an exchange Every futures contract has predetermined: - Quantity of commodity - Quality of commodity - Delivery location - Delivery date
© NCEL Why are Futures different to Equities? It is a “Promise”/ “Obligation” and not an “Asset” By buying/selling an “Asset” by paying the price in full there is no further liability – transaction over a short time period Buying/selling an “Obligation” only requires a margin hence you continue to be exposed to risk of paying additional margins till expiration A futures investor can sell a future without having first bought it if he is expecting prices of the commodity to go down in the future. This option is not available in stocks.
© NCEL Why are Futures different to Equities? Frequent checks on the Price of Futures given Convergence arising out of regular cycle of expiries It is important to emphasize that sellers of Futures have the same margin obligations as buyers Whereas, buyers may be called on to deposit additional margin when prices decline Sellers may be called on to deposit additional margin when prices increase Losses can be many times your investment (initial margin) and unlimited!
© NCEL Types of Futures Commodity Futures (Agricultural, Precious Metals, Base Metals, etc) Financial Futures (Bonds, Interest Rates, Currency, Stock indices, single stocks, etc) New Generation (Weather, Economic Indicators, Inflation, etc..) Implicit Futures (Property, Farms, etc)
© NCEL Futures v. Forwards FuturesForwards Exchange TradedOver-the-Counter (OTC) StandardisedNon-Standard Guaranteed SettlementNo Guarantee MarginedNo Margining All participants treated same Prices can vary according to credit risks LiquidityCan be illiquid
© NCEL History Implied Futures have been traded historically Japanese Rice Futures – 17th Century Chicago first example of modern futures exchange – Mid 19th Century Commodity Futures - first products Commodity Exchanges trade contracts on commodities and not commodities themselves
© NCEL Global Commodity Exchanges
© NCEL PMEX
© NCEL Highlights Demutualised, all-electronic commodity futures exchange Provide secure “Client Level” online access via the Internet with a unique id for each and every Client Broker/Client & Client/Client segregation of funds NCEL Clearing House will provide complete “Novation” – act as the Central Counterparty Settlement Guarantee Fund to provide complete protection for all open positions Investor Protection Fund to cover losses in case of closed positions and idle balances with Brokers Daily Marking-to-market of Open positions and collection of variation margin on T+0 basis, electronically Use of analytics for De-Risking NCEL and new product development
© NCEL Regulatory Framework Primary Legislation Securities and Exchange Ordinance 1969 Rules Commodity Exchange & Futures Contract Rules 2005 NCEL Regulations Regulations
© NCEL PMEX Regulations Exchange does not have any powers to make or grant exceptions Complete Segregation of funds: –Broker level (Broker/Client & Client/Client) –Clearing bank (Broker/Client) –Exchange (Broker/Client & Client/Client) Clearly defined events leading to financial and non- financial defaults Financial default leads to automatic cancellation of Membership
© NCEL Core Components of PMEX IT & SYSTEMS Trading Systems Connectivity and networks Database & Disaster Recovery Application development ANALYTICS Risk Management Research Real-time Analysis Software Specifications OPERATIONS Clearing and Settlement Margining and Accounting On-line Banking Delivery COMPLIANCE Member Services Surveillance and Monitoring Discipline and Enforcement Process Management PRODUCT RESEARCH & DEVELOPMENT Contract Development Specifications and Testing Logistics and Spot Market Practices
© NCEL What are Key Differentiators? Intellectual Capital is our greatest asset Use of state-of-the-art technology to offer transparent platform for easy and equal access to all market participants Unambiguous Trading Regulations to provide complete confidence and protection to investors and users Risk Management and Market Monitoring based on international “Best Practices” Thoroughly researched contract specifications to mirror market practices
© NCEL Is there a Social Value? Yes! Managing and transferring risk Generates publicly observable prices containing markets expectations of current and future economic value of certain assets Reduces price volatility and brings in stability Brings in standardization – quality Warehousing, Commodity Financing
© NCEL Benefits of a Derivatives Exchange Transparency in price discovery of both cash and futures Transferring risk from someone averse to risk to someone with an appetite Transitioning investors into a more controlled environment Creating savings and investments in the long run Developing intellectual capital and awareness Enhances markets image and standing, and leads to an increase in FDI
© NCEL Trader A Negotiate Price to go Short Negotiate Price to go Long Long ShortLong Short Clearing House Individualized Initial Margins & Margin Calls Clearing Deposits (Default Funds) Trader B Deposit Margin Clearing Deposit Financial Safeguards Novation- Central Counterparty
© NCEL Default Protection: Segregation of Participant Risk Clearing Participants Clearing Participants Market Participants Market Participants Prop SGF
© NCEL Default Protection: Segregation of Participant Risk Clearing Participants Clearing Participants Market Participants Market Participants X Prop X SGF Completely Isolated if a default takes place
© NCEL PMEX Trading System Trade Capture Pre-Trade Risk Management Mark to Market Position Update Market Monitoring Risk Mgmt Banking & Settlement Systems Update PMEX Trading Platform NCEL Broker Trader “A” Trader “B” Assigned Deal A & B Clients of NCEL Broker
© NCEL Contract Choice and Design Four out of Five new futures contracts fail and are de-listed within the first three years of trading Two possible reasons: –Lack of demand for the contract itself –Poor contract design Of course these two reasons are related to one another
© NCEL How do you Design a Contract? Research is critical to the success of a contract Interaction with market participants Simplicity Designed for industry to mirror industry practice Minimal entry/exit costs Ensure Price Convergence through credible threat of delivery Tracking of Basis - Responsibility of Market Oversight Dept.
© NCEL How do Prices Move over Time? Basis Prices Present Maturity Time Cash Futures
© NCEL What are Contract Specifications? The Asset –Quality & Certification requirements The Contract Size –Quantity Duration Delivery Arrangements –Location and Warehouses –Documentation required Delivery Months Price Quotes Price Limits Position Limits Margins
© NCEL PMEX Gold Futures Contract Contract Size: 100 gms of 995 Fineness Price Quotation: Rs/10 gms Monthly Expiries, starting with April Calendar Months available for trading Current Gold Price around Rs. 12,500/ 10 gms Contract Value around Rs. 125,000 Tick Size: Re. 1 Tick Value: Rs. 10 Initial Margin 4.25% Clearing Margin 2.50% (Leverage 40 times) Physically Deliverable Contract
© NCEL Risk Management
© NCEL Financial Risks Operational Risk Reputational Risk Business and strategic risks Market Risk Credit Risk What is Risk? Risk is multidimensional
© NCEL What is Risk? One can “slice and dice” these multiple dimensions of risk Replacement Cost Risk Settlement Risk Equity Risk Interest Rate Risk Currency Risk Commodity Risk Financial Risks Operational Risk Reputational Risk Business and strategic risks Market Risk Credit Risk
© NCEL What is Risk? Identification Risk Mitigation Strategy Replacement Cost Risk Settlement Risk Unmargined Risk Margined Risk Equity Risk Interest Rate Risk Currency Risk Commodity Risk Financial Risks Operational Risk Reputational Risk Business and strategic risks Market Risk Credit Risk
© NCEL Framework for Risk Management can be benchmarked in terms of: POLICIES METHODOLOGIES INFRASTRUCTURE Best Practice Risk Management »Policies »Methodologies »Infrastructure
© NCEL Framework for Risk Management can be benchmarked in terms of: POLICIES METHODOLOGIES INFRASTRUCTURE Best Practice Risk Management »Policies »Methodologies »Infrastructure Proactive Risk Management
© NCEL Risk PMEX
© NCEL Market Risk Mitigants Complete segregation – cornerstone Initial Margins determined using VaR –No netting-off between clients Pre-Trade Check Spot Month Delivery Margin Credits –Intra commodity spreads –Inter commodity spreads Daily Mark-to-Market of Positions Variation Margin in Cash only Daily Settlement Price Process
© NCEL Pre-Trade Check for Members & Clients Member/Client J-Trader Electronic Broker Buy/Sell Order If P or C (SODNLV) > Order Margin Required SARA Matching Engine Yes No System Back Office MCB SODNLV Updates
© NCEL Risk Management Example (illustration only) Settlement Price Lower Price Limit Upper Price Limit Spot Month Margin Initial Margin Variable Margin
© NCEL Credit Risk - Brokers Minimum Networth – ability to meet obligations with some balance sheet restructuring Segregated Net Capital Balance – Solvency & Liquidity Minimum Clearing Deposit Clearing Limit multiple of Clearing Deposit –E.g. minimum deposit Rs 0.5 million –Multiple 40 times (2.5% clearing deposit) –Clearing Limit = Rs20 million –Gross/Gross across all commodities and across all clients
© NCEL Other Tools & Measures Market Monitoring up to Client Level in real-time –To counter front running, wash trading, trading opposites, etc Unambiguous default provisions Misconduct, un-business like conduct and unprofessional conduct clearly defined Each and every participant has to follow the Regulations, Circulars, Notices and Guidelines Granting Exemptions or making exceptions not in PMEX’s vocabulary
© NCEL Position Limits Position Limits – Members & Clients To counter excessive speculation and manipulation –Limits the number of contracts that can be entered into: Gross across all clients Gross across all contracts Grossed up to the Member level Open contracts held by one individual investor with different brokers are combined using Client ID’sbrokers
© NCEL NCEL Trading System One of the costs for brokers is investment in client management and back office system However, NCEL being an equal opportunity provider offers this to its brokers for free PMEX will provide a complete end-to-end online trading & Client Management system to brokers: –Risk Management (pre-trade check), Electronic Fund Transfer, Margin Call generation, online 24/7 access to daily ledgers and accounting, secure access (USB key and personal digital certificates), access to historical data, etc. Margin calls with online bank transfers facility Pre-trade check and daily mark-to-market protects brokers from client defaults
© NCEL PMEX Technology Focus on availability, strong security, and ease of use State-of-the-art data center with biometric access control and fire protection system Redundant network both internal and external, multiple ISP links 100% Internet driven exchange Strong two factor authentication of traders using USB Keys (smart cards) Authentication based on Digital Certificate credentials Disaster recovery based on Veritas clustering, remote replication and tape library backup solutions Separate Disaster Recovery site for business continuity USB Key
© NCEL Trading on PMEX
© NCEL Trading on PMEX Investors have two methods of trading on PMEX: 1.Direct access to the market 2.Traditional route of placing orders through brokers In both cases, Broker is the Obligor to the Exchange Broker responsible for ensuring all Client Margins are paid Broker responsible for ensuring Clients comply with PMEX Regulations Broker responsible for Exposure/Margin/Position monitoring of all clients Broker earns commissions from both types of Clients Less Overheads if Clients allowed direct access
© NCEL NCEL Back Office Broker Brokerage House Segregated Margin Accounts Client Margin Payments Client A Rs.5,000 Client B Rs.5,000 PMEX Client A Ledger5,000 Client B Ledger5,000 Client Monitors Daily Ledgers Client A 5,000 Client B 5,000 Broker proprietary account Clearing Bank Clients give cheques /cash to Broker
© NCEL How to Start Trading? Contact an PMEX Registered Broker Enter Orders, Monitor Position, Pay Margins Ask for training, if using Direct Terminal Verify that Margins have been paid to PMEX Insist on Account Statements from Broker Payment of Initial Margin to Broker Broker Opens Trading Account If required, ask for Direct Trading Terminal Read and Sign Risk Disclosure Documents Step 1 Step 4 Step 5 Step 6 Step 7 Step 8 Step 9 Step 3 Step 2
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