An article in last Sunday’s Business Times caught my attention. The article was titled ‘SL first needs clearing house to up commodities, derivatives game’ and discussed some of the issues surrounding the establishment of a derivatives market in Sri Lanka, the use of Exchange Traded Funds, institutional market participation and short selling.
The article captured my interest and I thought it would be the opportune time to share some of my insights into how these markets operate and can be established based on my experiences in financial markets.
In terms of establishing a derivative market in Sri Lanka there are a few key things that are missing. As mentioned by the article this is a derivatives clearing house for the margining requirements of investors who open derivatives contracts. The second key component that is missing and probably the most important for a successful derivatives market is a type of market participant called a market maker.
A market maker is a participant that basically facilitates or establishes a market in a particular security and provides liquidity. Market makers exist in all the established equity and commodity options and futures markets around the world. Without the facilitation by these market makers it is very difficult for investors to find someone on the other side to buy or sell their derivative options or futures contract.
In simple terms let’s assume there was an call options contract over John Keels Holdings (meaning that you think JKH would increase in value) the market maker would make a market in the option contract based on the underlying value of JKH and other variables that make up options pricing. If you as an investor bought that options contract the market maker would then go into the share market and buy a certain number of shares in JKH to mitigate the risk if JKH and the options contract did in fact rise in value.
In my opinion the Colombo Stock Exchange (CSE) may potentially be able to get around the issue of a derivatives clearing house for equity derivatives and a new set of market and clearing rules, by using its existing infrastructure and allowing the issuance of derivative warrants contracts by an issuer (eg. broker or a bank). With company warrants already trading on the CSE, the listing of derivative warrants contracts would be a relatively simple process.
There would be no need for a new clearing house as the warrants contracts could be cleared and settled by the same clearing house and the onus of market making lies with the warrant issuer, who benefits from increased participation in their listed products, much like a fund manager when investors purchase their funds. The issuer would list their warrants over the underlying shares and instruments which investors could trade through their broker.
In terms of Exchange traded funds there are currently no ETFs in Sri Lanka. An Exchange Traded Fund is simply an open ended listed fund that tracks a particular market index. The creation and redemption process for ETFs is quite complex and once again involves a market maker in this process and there are ways to list ETFs over indices like the All Share Price Index even though the index lacks liquidity.
Short selling is an interesting concept and although it increases liquidity and price discovery in the market it is important for the CSE to create the right rules framework over short selling as it could be potentially very dangerous to the entire financial market, as we saw with many overseas financial markets during the global financial crisis. The CSE should place rules on how much of a share can be borrowed to short sell, whether this be say 5 or 10% of all issued capital.
(The writer is CEO of Ataraxia Capital Partners. He can be contacted at Nathan@ataraxiacapitalpartners.com)