Introducing NCEL

Karachi

Thursday, September 9, 2004

Background• NCEL established on April 20, 2002• Permission granted by SECP on May 16,

2002• Present Shareholders:

– KSE-40%– LSE-10%– ISE-10%– Pak Kuwait Investment Co. – 10% – Zarai Taraqiati Bank Ltd. – 10%

• Another FI has an approval for a 10% equity stake

Highlights• First de-mutualized exchange in Pakistan• First fully integrated electronic exchange

capable of also handling financial futures• First to employ modern risk management

techniques – Value-at-Risk • First to introduce the concept of “The Central

Counterparty” • First to introduce Vault Receipts and

Warehouse Receipts • First to become a “Digital Certification

Authority” in Pakistan – secure network access • First to deploy “Live Communications Sever”

Mission/VisionFROM• Limited access• Price distortions• Wide spreads or one way

quotes• Absence of

standardization• Counterparty risk• Impediments in financing• Lack of long term funding

or there is a mismatch

TO• Equal access to all• Observable future prices • Narrow spreads and two way

quotes• Quality certification &

standardization• Central Counterparty• Ease in financing• Vibrant long term market

“To provide an opportunity to the farmers to farm for the market”

Benefits of a Derivatives Exchange• Helps in price discovery of both cash and futures• Helps in transferring risk – averse to risk to someone

with an appetite• Helps in transforming cash markets into vibrant

markets• Helps in transitioning investors into a more controlled

environment• Helps in entrepreneurial activity in an economy• Helps in creating savings and investments in the long

run• Helps in developing intellectual capital and awareness

- enhances markets image and standing, and leads to an increase in FDI

360° Company Update• Hardware and software fully installed

• Members and their clients – Mock Trading

• Gold will be the first contract to be listed

• Regulations are ready and are to be approved by the Board and then SECP

• Clearing Bank has been appointed for online bank transfers (MCB)

• Cotton Yarn, Rice and Wheat contracts are being developed for Q4

360° Company Update Cont’d….

• 181 Members have been trained so far• Staff is highly educated and experienced

in trading futures, risk management, IT, investment banking, agriculture, textiles, financial mathematics, operations, corporate & securities law, stock-broking, accounting, tax, process improvement, etc……

• “Go Live” ?

Key Drivers of Success• Provide a transparent platform for easy and

equal access to all participants

• Regulations will provide complete confidence and protection to investors and users

• Risk Management, and Surveillance & Monitoring will be based on the international “Best Practices”

• Developing thoroughly researched contract specifications

Regulations• Conflict of interest clearly defined• Un-businesslike conduct, misconduct and

un-professional conduct have been introduced

• Board does not have the right to waive compliance

• Incorporated Corporate Code of Governance and “Best Business Practices”

• Committees only have recommendatory powers

Risk Management • Pre-trade risk checks• Clearing Deposits & Clearing Limits• Position Limits – Members & Clients• Variation margin – T+0 settlement in cash• Value-at-Risk methodology using Extreme Value

Theory• Provision for intra-day margin calls• Exchange reserves the right to enforce special

margins• A quantum leap ahead of the OTC market

Advantages of VaR• It captures an important aspect of risk

in a single number

• It is easy to understand

• It asks the simple question: “How bad can things get?”

• VaR models will be continuously back-tested and stress-tested

Margining - Example• Example – Gold

• VaR for Clearing Limit = 2 * Sigma = 3%– Clearing Deposit: Rs1.0 million = x 33.33

• VaR for Initial Margin = 4 * Sigma = 5%– Initial Margin: Rs0.5 million = x 20.00

• Initial Margin: 99% VaR over 1 day

• Spot/Delivery Month Margin: 99% VaR over 3 days

Pre-Trade Risk Management• Against an initial margin

• Can also set:– Maximum click trading limit

– Maximum order size

– Maximum sum of contract size limits

– Maximum long positions

– Maximum short positions

– Maximum intra-day loss

Pre-Trade Check

MemberJ-Trader

ElectronicBrokerBuy/Sell

Order

If P or C (SODNLV)<

Order MarginRequired

SARA

Matching Engine

Yes

NoPatsystems

Back Office

Bank

CollateralMgmt

System

SODNLV

Updates

BANK Accounts

NCEL

Member111-000-000

House111-000-1000

Client 1111-000-1001

Client 2111-000-1002

Client 3111-000-1003

Client 4111-000-1004

LEDGERMCB BANK

Daily Account Swipes

Member111-000-0000

House111-000-1000

Client 1111-000-1001

Client 2111-000-1002

Client 3111-000-1003

Client 4111-000-1004

Initial & Variation Margins

Daily Sweeping of accounts

NCEL is Central Counterparty• Upon matching of a trade, NCEL becomes a

buyer to every seller and a seller to every buyer and guarantees settlement

• The risk of each counterparty is transferred to a Central Counterparty (CCP)

• CCP is fundamental to the existence of a derivatives market

• NCEL has made an initial contribution of Rs100 million to its Settlement Guarantee Fund

Bilateral versus CCP (Multilateral)

Buyer Seller

Buyer Seller

CCP

Central Counterparty• Benefits of CCP:

– Acts as a Central Bank to Clearing Members– Simplifies Risk Management– Creates Process Efficiency– Increases Liquidity– Anonymity– Standardization of Processing

• Clearing Members are jointly and severally liable to ensure replenishment of the SGF, in case of a major payout

Online Market Surveillance • Clearing Limits

• Position Limits

• Crossing Trades (Member/Client) – 5 seconds standing in the market

• Wash Trading

• Front Running

• Trading Opposites – pre-arranged trading

Trading @ NCEL• Single Electronic front end trading platform

accessible up to the client level

• Using a single front end for trading on Multiple Markets

• Centralized Clearing & Settlement Infrastructure

• Multilateral Netting

• Cross Margining if we run multiple markets

Trading @ NCEL Cont’d…

• Front End Trading Platform should provide:– Can be used for accessing multiple markets (J

Trader being used by over 6,000 traders for accessing 13 Electronic Exchanges with 500,000 futures contracts being traded every single day)

– H Trader (hand held device such as a Palm Pilot)– Efficient screen based trading – Complete anonymity– Order driven with price/time priority

Trading on Multiple Markets

Technology • Features & Functionalities:

– Pre-Trade Check based on an initial margin for all

– Setting trading limits based on an initial margin – Monitoring of Clearing Limits in real time– Monitoring of Position Limits (Members and

Clients) in real time – Bank transfers– Capability of handling shares as collateral– Back Office ledgers - accounting– Share release and bank transfer instructions

Agriculture Sector• Platform for price discovery and hedging of

price risk for farmers• Provide a mechanism to lenders for

moving into collateralized commodity financing

• Introduce quality standardization• Impetus for investment in infrastructure• However, the pre-requisite would be an

efficient and a well developed out reach awareness program

Wheat Price Comparison between Major & Minor Markets of Pakistan

(For Three Years)

400

500

600

700

800

900

1000

Ru

pe

es

/10

0 K

g

Source: Federal Bureau of Statistics

Red = Average of Three Major Markets

Yellow = Average of 9 minor Markets

Sowing

Sowing Harvesting

Harvesting

Harvesting

Sowing

2000-01 2001-02 2002-03

Commodity Based Financing• Structured form of financing with an

objective of transferring risk from an entity to a commodity

• In discussion with an NGO to undertake financing as a pilot project on the following basis :1. Pre-sowing for inputs against NCEL

contract (short) and social collateral

2. Post-harvest and upon storage against a warehouse receipt

Other NCEL Initiatives

Analytics @ NCEL • Risk Management

– Should not be viewed as static – Time value of money– Being a CCP would require huge amount of risk

absorption– Using VaR to quantify and manage this risk– Initial Margin and Clearing Deposits to be determined

using VaR

• New Product Development– Benchmark Yield Curve– Interest Rate Risk– Interest Rate Futures– Stock Index Futures

What is wrong with YTM • A bond’s computed YTM will only actually

be earned if cash flows are immediately reinvested

• One cannot use YTMs of existing bonds to price a new issue

• YTM is not a pricing kernel• YTM believes the yield curve is flat; it is not

a path to thinking and understanding a non-flat yield curve

• It plays no role in the economics of fixed income markets

Zero Coupon Yield Curve• Provides a benchmark for valuing GOP

securities across all maturities irrespective of liquidity

• To study impact of monetary policy• Will help in asset and liability management

of institutions with substantial investment in GOP securities

• Has multiple uses including deriving forward currency rates

• Will take Pakistan a step closer to international markets

Deriving ZCYCThree main issues:1. Given a series of GOP securities, how do you

construct the yield curve?a. Linear Extrapolationb. Bootstrappingc. Cubic Splines

2. What GOP securities data should be used to construct it?

a. Primary auction data – last 6 monthsb. Secondary market data – individual instruments

3. What technique? a. Nelson Siegel b. Extended Nelson Siegel

ZCYC for Pakistan

Net Interest Margin

*Source: THK Banking Survey 2003

Observations:

1. All markets, other than Pakistan, have efficient screen based exchange traded interest rate hedging products

2. All markets, other than Pakistan, have benchmark yield curves

Net Interest Margin

Source: Malaysian Institute of Economic Research Publication

Present Money Market • Market trades on the YTM curve

• OTC – impedes price discovery

• Fragmented information - an impediment to liquidity

• Credit risk

• Extreme concentration

• Lack of Hedging Opportunities

Developing Interest Rate Futures Contract Specifications

• A 8.0% 2014 PIB new issue (example) will be quite liquid

• Could it be used as underlying for a interest rate futures contract?

• Problems:– Short squeeze– It would no longer be ’quite liquid’ in the future– It does not directly link up to hedging needs

Our Approach• Cash settlement to notional zero coupon

bond

• Interest rate futures based on the notional

T-Bills & PIBs

• Trading such a contract will not require spot market infrastructure - billions being transferred on a daily basis

• Eliminates “Cheapest to Deliver” games

Interest Rate Futures Contract • Notional 90 day & I Year T-Bills, Notional 5 Year

PIB with Coupon, Notional 10 Year Zero Coupon Bond, etc.

• Duration of Contracts – varied • Listing Frequency - initially, one every month• Cash settlement• Lot size, tick size, price steps, order size, etc. to

be determined together with market participants• Base price to be determined using theoretical

futures price - ZCYC

Thank You