Clearing & Settlement

National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for
all deals executed on the Derivatives (Futures & Options) segment. NSCCL acts as legal counter-
party to all deals on NSE's F&O segment and guarantees settlement. A Clearing Member (CM) of
NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members
(TM) on NSE, who clear and settle such deals through them.

Clearing Members

A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals
executed by Trading Members (TM) on NSE, who clear and settle such deals through them.
Primarily, the CM performs the following functions:

1.Clearing – Computing obligations of all his TM's i.e. determining positions to settle.
2.Settlement - Performing actual settlement. Only funds settlement is allowed at present in Index as
well as Stock futures and options contracts
3.Risk Management – Setting position limits based on upfront deposits / margins for each TM and
monitoring positions on a continuous basis.

Types of Clearing Members

• Trading Member Clearing Member (TM-CM): A Clearing Member who is also a TM. Such CMs
may clear and settle their own proprietary trades, their clients’ trades as well as trades of other TM’s
•Professional Clearing Member (PCM): A CM who is not a TM. Typically banks or custodians
could become a PCM and clear and settle for TM’s.
•Self Clearing Member (SCM): A Clearing Member who is also a TM. Such CMs may clear and
settle only their own proprietary trades and their clients’ trades but cannot clear
and settle trades of other TM’s.

Clearing Member Eligibility Norms

• SNet worth of at least Rs.300 lakhs. The net worth requirement for a CM who clears and
settles only deals executed by him is Rs. 100 lakhs.
• Deposit of Rs. 50 lakhs to NSCCL which forms the Base Minimum Capital (BMC) of the
CM.
• Additional incremental deposits of Rs.10 lakhs to NSCCL for each additional TM in case the
CM undertakes to clear and settle deals for other TMs.

Clearing Banks

NSCCL has empanelled 13 clearing banks namely Axis Bank Ltd., Bank of India, Canara Bank,
Citibank N.A, HDFC Bank, Hong kong & Shanghai Banking Corporation Ltd., ICICI Bank, IDBI
Bank, IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank of India and
Union Bank of India. Every Clearing Member is required to maintain and operate a clearing
account with any one of the empanelled clearing banks at the designated clearing bank branches. The
clearing account is to be used exclusively for clearing & settlement operations.

Clearing Mechanism

A Clearing Member's open position calculation is arrived by aggregating the open position of all the
Trading Members (TM) and all custodial participants clearing through him. A TM's open position in
turn includes his proprietary open position and clients’ open positions.
 a) Proprietary / Clients’ Open Position
While entering orders on the trading system, TMs are required to identify them as proprietary (if they
are own trades) or client (if entered on behalf of clients) through 'Pro / Cli' indicator provided in the
order entry screen. The proprietary positions are calculated on net basis (buy - sell) and client
positions are calculated on gross of net positions of each client i.e., a buy trade is off-set by a sell
trade and a sell trade is off-set by a buy trade

Settlement Mechanism
Futures Contracts on Index or Individual Securities
Daily Mark-to-Market Settlement

The positions in the futures contracts for each member are marked-to-market to the daily settlement
price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the previous day’s
settlement price, as the case may be, and the current day’s settlement price. The CMs who have
suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn passed
on to the members who have made a profit. This is known as daily mark-to-market settlement.

Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last
half an hour on a day, is currently the price computed as per the formula detailed below:

F = S * e rt
where :
F = theoretical futures price
S = value of the underlying index
r = rate of interest (MIBOR)
t = time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.
After daily settlement, all the open positions are reset to the daily settlement price.

CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs
and their clients clearing and settling through them. The pay-in and pay-out of the mark-to- market
settlement is on T+1 days ( T = Trade day). The mark to market losses or profits are directly debited
or credited to the CMs clearing bank account.

Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement
price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is
similar to the daily settlement process except for the method of computation of final settlement price.
The final settlement profit / loss is computed as the difference between trade price or the previous
day’s settlement price, as the case may be, and the final settlement price of the relevant futures
contract.Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank
account on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their
expiration day.

Options Contracts on Index or Individual Securities

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The premium payable
position and premium receivable positions are netted across all option contracts for each CM at the
client level to determine the net premium payable or
receivable amount, at the end of each day.
The CMs who have a premium payable position is required to pay the premium amount to NSCCL
which is in turn passed on to the members who have a premium receivable position. This is known as
daily premium settlement. CMs are responsible to collect and settle for the premium amounts from the
TMs and their clients clearing and settling through them. The pay-in and pay-out of the premium
settlement is on T+1 days ( T = Trade day). The premium payable amount and premium receivable
amount are directly debited or credited to the CMs clearing bank account.

Interim Exercise Settlement for Options on Individual

Securities

Interim exercise settlement for Option contracts on Individual Securities is effected for valid
exercised option positions at in-the- money strike prices, at the close of the trading hours, on the day
of exercise. Valid exercised option contracts are assigned to short positions in option contracts with
the same series, on a random basis. The interim exercise settlement value is the difference between
the strike price and the settlement price of the relevant option contract Exercise settlement value is
debited/ credited to the relevant CMs clearing bank account on T+1 day (T= exercise date ).

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the- money strike prices existing at the
close of trading hours, on the expiration day of an option contract. Long positions at in-the money
strike prices are automatically assigned to short positions in option contracts with the same series, on
a random basis. For index options contracts, exercise style is European style, while for options
contracts on individual securities, exercise style is American style. Final Exercise is
Automatic on expiry of the option contracts. Option contracts, which have been exercised,
shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is
cash settled by debiting/ crediting of the clearing accounts of the relevant Clearing Members
with the respective Clearing Bank. Final settlement loss/ profit amount for option contracts
on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T =
expiry day). Final settlement loss/ profit amount for option contracts on Individual Securities
is debited/ credited to the relevant CMs clearing bank account onT+1 day (T = expiry day).

Open positions, in option contracts, cease to exist after their expiration day. The pay-in / pay-out of
funds for a CM on a day is the net amount across settlements and all TMs/ clients, in F&O Segment.

Settlement of Custodial Participant (CP) Deals

NSCCL provides a facility to entities like institutions to execute trades through any TM, which may
be cleared and settled by their own CM. Such entities are called Custodial Participants (CP). To avail
of this facility, a CP is required to register with NSCCL through his CM, which allots them a unique
CP code. The CP and the CM are required to enter into an agreement as per specified format.
Thereafter, all trades executed by such CP through any TM are required to have the CP code in the
relevant field on the F&O trading system at the time of order entry. Such trades executed on behalf of
a CP are required to be confirmed by their CM (and not the CM of the TM through whom the trade
was executed), within the time specified by NSE, using the confirmation facility provided by NSCCL
to the CMs in the F&O segment. Till such time the trade is confirmed by the CM of the CP, the same
is considered as a trade of the TM and the responsibility of settlement of such trade vests with the CM
of the TM. Once the trades have been confirmed by the CM of the CP, they form part of the
obligations of the CM of the CP and they shall be responsible for all obligations arising out of such
trades including the payment of margins and settlement of obligations.
History

The history of derivatives is quite colourful and surprisingly a lot longer than most people think.
Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a
specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to
provide the masses with their supply of Egyptian grain. These contracts were also undertaken between
farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward
contracts have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence in the early 1700’s
in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed
in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralised location to
negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity
‘futures’. The first type of futures contract was called ‘to arrive at’. Trading in futures began on the
CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as
the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many
commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was
formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’
(CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the
currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on
International Monetary Market (IMM), a division of CME. The currency futures traded on the
IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German
Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate
futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975.
Stock index futures and options emerged in 1982. The first stock index futures contracts were traded
on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered
a trading link between two exchanges, was formed between the Singapore International Monetary
Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are
very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly
coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up.
Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people
even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze
collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an American financier, Russell Sage, in
1872. These options were traded over the counter. Agricultural commodities options were traded in
the nineteenth century in England and the US. Options on shares were available in the US on the over
the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms
known as Put and Call brokers and Dealer’s Association was set up in early 1900’s to provide a
mechanism for bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at
CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes
invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of
an option which led to an increased interest in trading of options. With the options markets becoming
increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange
(PHLX) began trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of
the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the
international financial markets paved the way for development of a number of financial derivatives
which served as effective risk management tools to cope with market uncertainties.
The CBOT and the CME are two largest financial exchanges in the world on which futures contracts
are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more
than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE
trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is
the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the
Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei
225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have become the most
important markets in the world. Today, derivatives have become part and parcel of the day-to-day life
for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was
using traditional out-dated methods of trading. There was a huge gap between the investors’
aspirations of the markets and the available means of trading. The opening of Indian economy has
precipitated the process of integration of India’s financial markets with the international financial
markets. Introduction of risk management instruments in India has gained momentum in last few
years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options
etc. which have developed into a very large market

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the
markets, technological developments and advances in the financial theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects having value maybe
commodities, local currency or foreign currencies. The concept of price is clear to almost everybody
when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol,
metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And
the price one pays in one’s own currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have ‘demand’ and
producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the
market determines the price. These factors are constantly interacting in the market causing changes in
the price over a short period of time. Such changes in the price are known as ‘price volatility’. This
has three factors: the speed of price changes, the frequency of price changes and the magnitude of
price changes. The changes in demand and supply influencing factors culminate in market
adjustments through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS agreement brought
and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The
globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a
new scale and dimension to the markets. Nations that were poor suddenly became a major source of
supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought
the price volatility factor on the surface. The advent of telecommunication and data processing bought
information very quickly to the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments. Even equity holders are exposed to price
risk of corporate share fluctuates rapidly. These price volatility risks pushed the use of derivatives like
futures and options increasingly as these instruments can be used as hedge to protect against adverse
price changes in commodity, foreign exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the
world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly
enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower
cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit
margins.In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness
of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because
of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south
East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing
its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and
financial activities necessitates use of derivatives to guard against future losses. This factor alone has
contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological break through.
Advances in this area include the development of high speed processors, network systems and
enhanced method of data entry. Closely related to advances in computer technology are advances in
telecommunications. Improvement in communications allow for instantaneous world wide
conferencing, Data transmission by satellite. At the same time there were significant advances in
software programmes without which computer and telecommunication advances would be
meaningless. These facilitated the more rapid movement of information and consequently its
instantaneous impact on market price.Although price sensitivity to market forces is beneficial to the
economy as a whole resources are rapidly relocated to more productive use and better rationed
overtime the greater price volatility exposes producers and consumers to greater price risk. The effect
of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the technological developments
increase volatility, derivatives and risk management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES –

Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional
form, was the only hedging tool available. Option pricing models developed by Black and Scholes in
1973 were used to determine prices of call and put options. In late 1970’s, work of Lewis Edeington
extended the early work of Johnson and started the hedging of financial price risks with financial
futures. The work of economic theorists gave rise to new products for risk management which led to
the growth of derivatives in financial markets. The above factors in combination of lot many factors
led to growth of derivatives instruments

3.10 BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:
1.] RISK MANAGEMENT –
Futures and options contract can be used for altering the risk of investing in spot market. For instance,
consider an investor who owns an asset. He will always be worried that the price may fall before he
can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the
spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help
offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put
option can always be exercised.
2.] PRICE DISCOVERY –
Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are
believed to contain information about future spot prices and help in disseminating such information.
As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining
to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring
the correct allocation of resources in a free market economy. Options markets provide information
about the volatility or risk of the underlying asset.
3.] OPERATIONAL ADVANTAGES –
As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer
greater liquidity. Large spot transactions can often lead to significant price changes. However, futures
markets tend to be more liquid than spot markets, because herein you can take large positions by
depositing relatively small margins. Consequently, a large position in derivatives markets is relatively
easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the
spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in
spot markets.
4.] MARKET EFFICIENCY –
The availability of derivatives makes markets more efficient; spot, futures and options markets are
inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit
arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure
that prices reflect true values.
5.] EASE OF SPECULATION –
Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions.
Also, the amount of capital required to take a comparable position is less in this case. This is
important because facilitation of speculation is critical for ensuring free and fair markets. Speculators
always take calculated risks. A speculator will accept a level of risk only if he is convinced that the
associated expected return is commensurate with the risk that he is taking.
CONCLUSION
Financial derivatives have grown rapidly in recent years due to improvements in computer
technology, innovations in financial theory, and the need to manage risks arising from volatility in the
interest and currency exchange rates. Derivatives are increasingly being used to manage various kinds
of risk exposure, to obtain desirable financing, and to enhance investment and speculative
opportunities.

Types of risk:

Credit Risk: When one of the two parties fails to perform its role as per the agreement, this is called
the credit risk. It can also be referred to as default or counterparty risk. It varies with different sources.

Market Risk: This is a kind of financial loss that takes place due to the adverse price movements of
the underlying variable or instrument.

Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can be
referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario. First is
concerned with the liquidity of separate items and second is related to supporting the activities of the
organization with funds comprising derivatives.

Legal Risk:Legal issues related with the agreement need to be scrutinized well, as one can deal in
derivatives across the different judicial boundaries.

Systematic Risk - Systematic risk influences a large number of assets. A significant political event,
for example, could affect several of the assets in your portfolio. It is virtually impossible to protect
yourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of
risk affects a very small number of assets. An example is news that affects a specific stock such as a
sudden strike by employees. Diversification is the only way to protect yourself from unsystematic
risk. (We will discuss diversification later in this tutorial).

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the
contractual interest or principal on its debt obligations. This type of risk is of particular concern to
investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal
government, have the least amount of default risk and the lowest returns, while corporate bonds tend
to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of
default are considered to be investment grade, while bonds with higher chances are considered to be
junk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are
investment-grade, and which bonds are junk

Country Risk - Country risk refers to the risk that a country won't be able to honor its financial
commitments. When a country defaults on its obligations, this can harm the performance of all other
financial instruments in that country as well as other countries it has relations with. Country risk
applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country.
This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that
currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all
financial instruments that are in a currency other than your domestic currency. As an example, if you
are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share
value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American
dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a
change in interest rates. This risk affects the value of bonds more directly than stocks

Political Risk - Political risk represents the financial risk that a country's government will suddenly
change its policies. This is a major reason why developing countries lack foreign investment.

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is
the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As
a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility
is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it
refers to the behavior, or "temperament", of your investment rather than the reason for this behavior.
Because market movement is the reason why people can make money from stocks, volatility is
essential for returns, and the more unstable the investment the more chance there is that it will
experience a dramatic change in either direction.

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as
swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to
disclosure of information between the parties, since the OTC market is made up of banks and other
highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because
trades can occur in private, without activity being visible on any exchange. According to the Bank for
International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008). [7]
Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9%
are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are
other. Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party
relies on the other to perform.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where
individuals trade standardized contracts that have been defined by the exchange.[8] A derivatives
exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides
of the trade to act as a guarantee. The world's largest[9] derivatives exchanges (by number of
transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which
lists a wide range of European products such as interest rate & index products), and CME Group
(made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade
and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined
turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of
derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such
as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also,
warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and
various other instruments that essentially consist of a complex set of options bundled into a simple
package are routinely listed on equity exchanges. Like other derivatives, these publicly traded
derivatives provide investors access to risk/reward and volatility characteristics that, while related to
an underlying commodity, nonetheless are distinctive.

The OTC derivatives markets have the following features compared to exchange-traded
derivatives:

1) The management of counter-party (credit) risk is decentralized and located within individual
institutions,

2) There are no formal centralized limits on individual positions, leverage, or margining; limits are
determined as credit lines by each of the counterparties entering into these contracts

3) There are no formal rules for risk and burden-sharing,

4) There are no formal rules or mechanisms for ensuring market stability and integrity, and for
safeguarding the collective interests of market participants, and

5) Although OTC contracts are affected indirectly by national legal systems, banking supervision and
market surveillance, they are generally not regulated by a regulatory authority.

Some of the features of OTC derivatives markets embody risks to financial market stability. The
following features of OTC derivatives markets can give rise to instability in institutions, markets, and
the international financial system:

(i) The dynamic nature of gross credit exposures;

(ii) Information asymmetries;

(iii) The effects of OTC derivative activities on available aggregate credit;

(iv) The high concentration of OTC derivative activities in major institutions; and

(v) The central role of OTC derivatives markets in the global financial system.