Prospective Investor
@
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
Futures
Forwards
Exchange Traded
Over-the-Counter (OTC)
Standardised
Non-Standard
Guaranteed Settlement
No Guarantee
Margined
No Margining
All participants treated same
Prices can vary according to
credit risks
Liquidity
Can 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
© NCEL
margin on T+0 basis, electronically
Regulatory Framework
Primary Legislation
Securities and
Exchange
Ordinance 1969
Rules
Commodity
Exchange &
Futures Contract
Rules 2005
Regulations
NCEL
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 nonfinancial defaults
• Financial default leads to automatic cancellation of
Membership
© NCEL
Core Components of PMEX
IT & SYSTEMS
•
•
•
•
ANALYTICS
•
•
•
•
Trading Systems
Connectivity and networks
Database & Disaster Recovery
Application development
Risk Management
Research
Real-time Analysis
Software Specifications
OPERATIONS
•
•
•
•
COMPLIANCE
•
•
•
•
Clearing and Settlement
Margining and Accounting
On-line Banking
Delivery
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
Novation- Central Counterparty
Negotiate Price to go Short
Trader A
Long
Short
Clearing
House
Individualized Initial Margins & Margin
Calls
Clearing Deposits (Default Funds)
© NCEL
Clearing Deposit
Long
Deposit Margin
Deposit Margin
Short
Clearing Deposit
Trader B
Negotiate Price to go Long
Financial
Safeguards
Default Protection: Segregation of
Participant Risk
Market
Participants
Clearing
Participants
SGF
Clearing
Participants
Market
Participants
Prop
Prop
Prop
© NCEL
Default Protection: Segregation of
Participant Risk
Market
Participants
Clearing
Participants
SGF
Clearing
Participants
X
Market
Participants
Prop
X
Prop
Prop
© NCEL
Completely Isolated if
a default takes place
PMEX Trading System
PMEX Trading Platform
Assigned
Deal
NCEL Broker
Trade Capture
Pre-Trade Risk
Management
Position
Update
Mark to
Market
Market
Monitoring
Trader “A”
Systems
Update
Banking &
Settlement
Trader “B”
A & B Clients of
NCEL Broker
© NCEL
Risk
Mgmt
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?
Prices
Futures
Basis
Cash
Time
Present
Maturity
© 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 2007
• 3 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
What is Risk?
• Risk is multidimensional
Market Risk
Credit Risk
Financial
Risks
Operational Risk
Reputational Risk
Business and strategic risks
© NCEL
What is Risk?
• One can “slice and dice” these multiple
dimensions of risk
Equity Risk
Market Risk
Interest Rate Risk
Currency Risk
Credit Risk
Commodity Risk
Financial
Risks
Operational
Risk
Reputational
Risk
Business and
strategic risks
© NCEL
Settlement Risk
Replacement Cost
Risk
What is Risk?
• Identification
Risk Mitigation Strategy
Equity Risk
Market Risk
Interest Rate Risk
Margined Risk
Currency Risk
Credit Risk
Commodity Risk
Financial
Risks
Operational
Risk
Reputational
Risk
Settlement Risk
Replacement Cost
Risk
Business and
strategic risks
© NCEL
Unmargined
Risk
Best Practice Risk Management
• Framework for Risk Management can be
benchmarked in terms of:
» Policies
» Methodologies
» Infrastructure
© NCEL
Best Practice Risk Management
• Framework for Risk Management can be benchmarked
in terms of:
» Policies
» Methodologies
» Infrastructure
© NCEL
Risk Management
@
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
Buy/Sell
Order
Electronic
Broker
MCB
SARA
No
SODNLV
If P or C (SODNLV)
>
Order Margin
Required
Yes
Matching Engine
© NCEL
Updates
System
Back Office
Risk Management Example
(illustration only)
60
50
Upper Price Limit
40
Settlement Price
30
Lower Price Limit
20
10
Variable
Margin
Spot Month Margin
Initial Margin
iv
er
y
D
el
Sp
ot
M
on
M
on
th
s
B
eg
in
in
g
Tr
ad
th
0
© 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’s
© 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
© NCEL
continuity
USB Key
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
Clients give cheques /cash to
Broker
Client Margin Payments
Client Monitors Daily Ledgers
Client A
Rs.5,000
Clearing Bank
Client B
Rs.5,000
Brokerage House
Rs. 5,000
PMEX
Rs. 5,000
Segregated Margin Accounts
NCEL Back Office
Broker
Broker
proprietary
account
Client A
5,000
Client B
5,000
© NCEL
Client A Ledger
5,000
Client B Ledger
5,000
How to Start Trading?
Step 1
Contact an PMEX Registered Broker
Step 2
Read and Sign Risk Disclosure Documents
Step 3
If required, ask for Direct Trading Terminal
Step 4
Broker Opens Trading Account
Step 5
Payment of Initial Margin to Broker
Step 6
Insist on Account Statements from Broker
Step 7
Verify that Margins have been paid to PMEX
Step 8
Ask for training, if using Direct Terminal
Step 9
Enter Orders, Monitor Position, Pay Margins
© NCEL
www.pmex.com.pk
© NCEL