Pakistan’s derivatives markets


Pakistan’s derivatives markets Derivatives are complex financial instruments that are used by retail and institutional investors for risk management. They derive their value from the ‘underlying’ source, such as financial assets, commodities, currencies, or interest rates.

Some derivatives (futures and options) trade on organised exchanges, while others (forward contracts, options, and swaps) trade on over-the-counter (OTC) markets.

The contracts on exchanges are characterised by standardisation, high regulation, liquidity, no default risk, and low transaction costs. On the other hand, OTC contracts are customised to the needs of the parties involved, are less marketable with high counterparty default risk, and are loosely regulated.

Investors’ interest in the country’s exchange-traded financial and commodities-based derivatives is marginal, resulting in unimpressive turnovers

There are approximately 80 organised derivatives exchanges internationally. However, according to the International Bank of Settlements (2016), less than 20pc of the notional amount outstanding is traded on exchanges, and the magnitude and scope of OTC transactions is far greater than the exchange-traded transactions.

The maturity of the spot markets, investors’ financial literacy, the appropriate regulatory framework, and liquidity are the key determinants of well-functioning derivatives markets.

The characteristics of the underlying, such as price transparency and volatility, suitability of cross hedge, a homogenous product with established grades and standards for quality and quantity, and hedging effectiveness, are important in the success of derivatives instruments.

In Pakistan, derivatives based on financial assets trade on the Pakistan Stock Exchange (PSX), while commodity-based derivatives trade on the Pakistan Mercantile Exchange (PMEX).

While the trading of cash settled and deliverable equity futures on the PSX started in 2001, the PMEX became operational in 2007.

Despite the exceptional performance of the Pakistani stock market in recent years, investors’ interest in exchange-traded derivatives is marginal, resulting in unimpressive turnovers. In fact, Pakistan’s derivative markets rank the lowest in the region in terms of volumes traded.

In contrast, the Indian derivatives market, the National Stock Exchange, has become the most active market in the region in recent years. The Chinese derivatives markets have taken a lead in product innovation and have introduced derivatives with non-traditional underlying commodities.

Several supply and demand side challenges impede the development of derivatives markets in Pakistan.

On the supply-side, a lack of marketing and awareness about derivatives, a slack in product innovation, inadequate training and education of supply-side market participants, and excessive regulations, have all restrained the growth of derivatives.

Moreover, derivatives could not get their due share of attention until the Badla/CFS transactions were abolished in 2009, as these transactions fulfilled investors’ need for leverage-based products.

On the demand-side, the challenges are even more complex. The savings rate in Pakistan, as measured by the savings to GDP ratio, has been historically low. In fact, it is the lowest in the region when compared to China, India, Sri Lanka, and Bangladesh.

Besides a low savings rate, the investor base has been stagnant since the inception of the PSX in 1948 and is only one-fourth of the investor base of Bangladesh.

These challenges can potentially be explained by a lack of financial literacy amongst investors, limited reach of investment companies, narrow product portfolios, and most importantly, the paucity of investors’ confidence in the Pakistani capital markets.

With respect to institutional investors, accounting treatment of derivatives on financial statements may be a limiting factor in their participation in organised derivatives markets.

Certain factors such as Pakistan’s recent MSCI reclassification to emerging market status and inclusion in the ‘Next-11’ group, an improvement in macro-economic indicators, a decline in discount and deposit rates, and the need for leverage-based products may positively impact the derivatives markets in the country.

A few recommendations may help in promoting and developing the nascent Pakistani derivatives markets.

First, it is appropriate to understand and address the concerns of the supply-side market participants.

Second, a comparative analysis of regulatory frameworks in neighbouring countries, other emerging markets, and developed markets would help in formulating the regulatory levels that not only safeguard investors’ interest but also promote the derivatives markets.

Third, the innovation of Shariah-compliant derivatives contracts may attract investors who view derivatives as purely speculative instruments.

Fourth, appropriate measures to promote the marketability of derivatives, as well as cash liquidity of the supply-side market participants, should be considered. While the former can be achieved by low transaction costs, price discovery, high volumes, and enhancement of the market’s resilience to negative shocks, the latter can be achieved by keeping the margin requirements at a level that do not increase the opportunity cost for retail and institutional investors.

Fifth, financial literacy and confidence building among investors, regulated marketing campaigns in simple language, and increasing the reach of investment companies through online platforms, satellite offices, and already established banking networks may motivate retails investors to opt for investments in derivatives.

Lastly, encouraging investors’ participation in derivatives markets through mutual funds and voluntary pension schemes within the realm of respective investment policies would also deepen the derivatives markets.

Given that the excessive and unregulated use of derivatives is blamed for the financial crisis in 2008, the PSX, PMEX, and SECP have been extremely cautious in developing regulatory frameworks pertinent to the use of derivatives, which in a way has hampered their acceptance and growth in Pakistan.

While significant progress has been made to develop derivatives markets in Pakistan, the desired results are yet to be achieved with respect to increased volumes, values, and product innovation.

The writer is based in Toronto and a non-resident research consultant at the Institute of Financial Markets of Pakistan


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