BBF IFC

Bombay Stock Exchange Brokers’ Forum
A COMPARATIVE STUDY OF

INTERNATIONAL FINANCE CENTRES

Narsee Monjee Institute of Management Studies

SWOT ANALYSIS

INDIA
The Global Competitiveness Report 2014-2015 assesses the competitiveness landscape of 144
economies, providing insight into the drivers of their productivity and prosperity.
On a downward trend since 2007 and dropping by 11 more places this year India Ranks 71st.



London IFC

Following factors are considered most important to evaluate the financial centers:
1. Availability of Skilled Persons
2. Regulatory Environment
3. Availability of Business Infrastructure
4. A Fair and Just Business Environment
5. Government Responsiveness
6. Corporate Tax Regimes
7. Operational Costs
8. Access to Suppliers of Professional Services
9. Quality of Life
10. Culture & Language
11. Quality/ Availability of Commercial Property
12. Personal Tax Regime

In terms of assets, London is the largest and most established such center, followed by New York,
the difference being that the proportion of international to domestic business is much greater in the

former.

Availability of Skilled Persons

London score high on the availability of skilled of staff, with a rating of Good or Excellent. Many
believe that London is the only place in Europe to centralize their operations because of the
flexibility of the labour market. London have a “just-in-time” workforce – well trained and available
when required, but easily reduced when necessary.

Indian Scenario

Indian scenario is continuously changing providing more skilled persons for work. Education is given
most important and the subject of International Finance is taken up seriously in many MBA colleges
across country. Some institutes are developed having core strength in International Finance. This will
lead to more skilled persons and therefore better ideas working for IFC in India

Regulatory Environment

The issue that business leaders are most worried about is over-regulation and the costs of
compliance in their industries. Generally the Financial Services Authority (FSA) of London is well
regarded and people see benefit it there only being one main regulator that oversees the financial
services industry in London. The only criticism we heard of the FSA was that it was overstretched
and had some poor quality staff at the more junior levels.The FSA favors an environment where
principles of regulation are published and there is a degree of discretion as to how these principles
are applied. The FSA also favor a risk-based approach to regulation where financial institutions
concentrate their compliance efforts in areas where there is the highest risk.

Indian Scenario

The regulatory environment in India is considered to be very stringent and not flexible. Also the
system takes a lot of time in settlement of cases and laws being passed. For an IFC, the law system
has to be separate from civil court system. Special courts and system has to be placed to take care of
the cases on a case to case system and not a general judicial system. The system has to corruption
free with no red tapism.

Availability of Business Infrastructure

Most developed cities have good infrastructure and even places in India are getting much better –
the main difference is when something goes wrong – in the West we get it fixed fast but in Mumbai
there is no urgency at all to resolve the problem. – Head of Global Operations – European Investment
Bank - based in London.

The above statement shoes the urgency to change the business environment in India.

DOING BUSINESS 2015 DOING BUSINESS CHANGE IN RANK
RANK 2014 RANK***
-2
142 140

DOING BUSINESS 2015 DOING BUSINESS
DTF** (% POINTS) 2014 DTF** (%
POINTS)
53.97
52.78

Business Reforms made in India

Starting a Business:
India made starting a business easier by considerably reducing the registration fees, but also made it
more difficult by introducing a requirement to file a declaration before the commencement of
business operations. These changes apply to both Delhi and Mumbai.

Protecting Minority Investors:
India strengthened minority investor protections by requiring greater disclosure of conflicts of
interest by board members, increasing the remedies available in case of prejudicial related-party
transactions and introducing additional safeguards for shareholders of privately held companies.
This reform applies to both Delhi and Mumbai.

Getting Electricity:
In India the utility in Mumbai made getting electricity less costly by reducing the security deposit for
a new connection.
These reforms and other such are required to make the government so that foreign companies find
doing business in India much simpler. Any unwanted element should be removed as soon as it is
recognized.
Other factors listed above also states that London IFC has over the years developed a reputation of
being most effective as it handles the most traffic. Indian IFC needs to develop a separate law
system for speedy delivery, helping government norms, and ease of doing business.

HONG KONG IFC

Common law system: Under the “One country, Two systems” principle, Hong Kong

has retained its common law system. The rule of law, upheld by an independent judiciary, is
the cornerstone of Hong Kong’s success as a leading commercial and financial centre,
providing an efficient and secure environment for individuals and businesses.

Recommendation: Indian IFC should have separate law based on best practices around the
world and more focus should be given on quick dispute resolution and providing best
arbitration opportunities.

Robust regulatory regime: Hong Kong has put in place a robust regulatory regime

which has stood the tests of numerous financial crises: 1994 Mexican and Latin America
“Tequila” crisis; 1997 Asian financial crisis; 1998 Russian default and Long-Term Capital
Management crisis; 2000 dotcom crash; and 2008 global financial meltdown. Hong Kong’s
regulatory regime has evolved with consistency and predictability. As an essential player in
the global financial arena, Hong Kong has built a fair, open and orderly financial system on
par with international best practice. And we actively contribute to help define the
international regulatory standards in many aspects, from risk management to investor
protection.

Recommendation: SEBI, RBI and IRDA have already announced that they are going to
open their offices in GIFT city. Regulatory environment in IFC should be focused on
increasing liquidity in the market and allowing development of new products like REITs and
Commodity Futures. Upcoming IFCs around the world have established themselves as
favorable location for IPOs and therefore Indian regulators should also try to promote IPOs in
IFC so that foreign companies can raise money in India.

Simple and transparent taxation system: Hong Kong has a simple, transparent

and stable taxation system. Company profits tax is 16.5% and personal income tax is capped
at 15%. There is no sales tax, no withholding tax on dividends and interest, no capital gains
tax, no value-added tax and no estate duty.

Hong Kong is a free port and generally imposes no customs duties on imported goods, with a
few limited exceptions.

Hong Kong also has a growing network of comprehensive double taxation agreements
(CDTAs) with its major trading and investment partners, and more discussions ongoing. The
resulting tax certainty for companies from a jurisdiction with which Hong Kong has signed a
CDTA better supports their future business development and expansion strategies. As at the
end of September 2013, we had signed CDTAs with 29 jurisdictions (a) and concluded
CDTAs with four jurisdictions(b). We are having or will soon have CDTA talks with about
10 jurisdictions.

Recommendation: Taxation regime for Indian IFC can be replicated directly from Hong

Kong which provides minimum taxation and allows companies to grow while ensuring that

no money laundering is done. Also, a clear tax policy should be established which will send

out the message that India is a safe place ofr investment and boost

confidence in the markets.

Connectivity: Airport connectivity to all the major financial centres of the world

especially direct flights to major Asian centres.

Infrastructure: The electricity grid is state-of the-art and supply is more than adequate.

Blackouts are not part of the vocabulary. Drinking water is readily and reliably available.
Taxis operate around the clock. Mobile phones connect – even in tunnels and in the
underground railway. The telecommunications system is fully digitised.
Recommendation: It is important to set up a world class infrastructure to increase the ease of
doing business and connectivity and telecom infrastructure are vital in setting up
communication with foreign markets.

Setting up business in IFC:

• The procedures for incorporation of a new private limited company and registration of a
branch of foreign company in Hong Kong are simple and straightforward.
• The time frame for incorporation of a limited company can be as short as 24 hours for
online applications, whilst it takes about 14 days to register a foreign company as a non-Hong
Kong company in Hong Kong.
Recommendation: Policies should be made in such a manner that all the red tape is
eliminated and time taken to establish business is minimum as per global standards.

Immigration:Non-Hong Kong residents who have obtained a degree or higher

qualification in a full-time and locally accredited programme in Hong Kong (‘non-local
graduates‘) may apply to stay or return and work in Hong Kong under the ‘Immigration

Arrangements for Non-local Graduates‘.

Recommendation: While we should ensure that sufficient talent pool is developed in country
by partnering with various schools and colleges around the country, we should also ensure
that enough opportunities are provided to foreign nationals to come and work in India.

Dubai IFC

The DIFC is a unique example of a successful financial industry cluster development. Unlike most
financial centers elsewhere in the world, which have developed over a long period of time, DIFC has
created a thriving industry ecosystem and a vibrant financial services cluster within just five years

In the region characterized by civil law codes, DIFC introduced a common-law framework designed
to offer the optimal environment for business growth. All business activity within DIFC is governed
by this legal framework with the exception of criminal issues, which are governed by UAE’s Federal
Criminal Law.

 At the heart of the DIFC model is an independent regulator, the Dubai Financial Services
Authority (DFSA), which licenses and regulates the activities of all banking and financial
institutions and ancillary service provider

India has a bad reputation when it comes to regulations and ease of doing business. So it becomes
imperative that a separate authority like DFSA be incorporated in the Indian IFC. This new
authority/institution should be made responsible to regulate the activities of not only the Banking,
Financial institutions and Ancillary service provider but also service providers such as technology
companies, lawyers and accountants. This will help in attracting investors to the IFC.

Dubai has setup an independent judicial system within the financial district.

This becomes critical for India as there are many cases piled up in the Indian Judicial system still
waiting for justice. There is a dearth of courts (measured by one court per x people) in India
compared to other countries.

A Separate Judicial system should be set up for the Indian IFC. The rules of which should be designed
specifically to deal with sophisticated financial transactions conducted within the IFC. Further the
courts set up in the IFC should work extensively to ensure the highest international standards of
legal procedures in order to provide the certainty, flexibility and efficiency expected by global
institutions operating within the IFC.

Along with the legal and regulatory authorities a separate Corporate Governance Institute should be
set up to promote better corporate governance standards and practices across the region.
Ultimately this will contribute to greater efficiency and competitiveness among the established
regional financial exchanges and institutions.

DIFC growth in registration and Employment

Dubai International Financial Centre (DIFC) reported an 18 percent increase in the number of active
registered companies operating, reaching 1,225 at the end of 2014, compared with 1,039 in 2013. A
total of 242 new companies were licensed during 2014, compared with 199 new companies licensed
in 2013, representing an increase of 22 percent, DIFC said in a statement. The growth in new
companies means that on average, DIFC granted licenses to one new company every working day of
the year. Only the boom year of 2008 registered a higher number of new company licenses. The
total workforce rose to 17,860 people, from 15,600 at the end of 2013. The number of net new jobs
created in 2014 was 42 percent more than the net new jobs created in 2013, the statement added.
Net additional leased commercial office space increased 15 percent, reaching 282,000 square feet in
2014. Of the 1,225 total active firms at the end of 2014, there were 362 financial services firms, 682
non-financial services firms and 171 retailers.

References-http://www.arabianbusiness.com/dubai-s-difc-says-most-new-licences-issued-since-2008-

586117.html#.Vfk56fmqqko

Impact on economy?
The Dubai International Financial Centre (DIFC), ranked as the world's fastest-growing international
financial center, contributed 12.1 per cent to Dubai’s gross domestic product (GDP) in 2013 with the
contribution of financial services sector being over 15 per cent, according to DIFC Governor.
Employment requirement in Indian IFC as per McKinsey report

Majority of the jobs in IFC would require skilled labor. There is a shortfall in skilled labors in India.
Part of the skilled labor could be sourced from the Business school but only few business schools
offer the course of International finance. Government should promote the course in the Business
schools and also set up a training center for graduates to train and get placed in IFC.

Fund Management

Fund management refers to whole array of services like wealth management, movement of funds at
a bank by treasury, mutual funds, alternate investment of funds. In our study we are restricting
ourselves to the domain of asset management companies and trying to understand various
guidelines in some of the developed and evolving financial centres of the world. Taking cues from
the guidelines and applying it in Indian context, we have come up with certain recommendations.

Scenario in International IFCs

• In accordance with its government-led economic policy, the MAS (Monetary Authority of
Singapore) has targeted the development of the fund management as a key element of the
financial sector as identified by the 1997 Committee. Numerous incentives are provided by
the government to encourage international fund managers to operate in Singapore.

• Some of the offered incentive are including tax concessions, grants, and also allocations of
CPF (Central Provident Fund) money

• In 1998, the CPF Board announced that it would earmark S$35 billion (US$21 billion) as seed
money to promote the development of the sector.

Monetary Authority of Singapore facilitates the establishment of various safety-net schemes

• Deposit Insurance Scheme and the Policy owners’ Protection Scheme. Both are privately
funded by the participating banks and insurance companies, respectively. The establishment
of such safety-net schemes is important given that MAS cannot prevent all failures.
Consumers can then know exactly how much of their money will be fully protected or
whether their losses arising from insured perils will be compensated if an institution fails.
This will help to strengthen market discipline and dispel any public misperception of a
government guarantee in the event of a failure.

• MAS requires approved exchanges to maintain a fidelity fund to give a certain level of
protection to investors trading on these exchanges against acts of defalcation and default on
the part of the broker/dealers.

Taxbenefits

• Currently those on the list of Approved Fund Managers (AFMs) are accorded a concessionary
tax rate of 10% on fees and commission derived from any funds managed, investment
advisory services provided or loan of securities.

• Tax holidays will also be considered for fund managers who manage more than S$5 billion of
foreign investor’s funds in Singapore and are accorded the Enhanced Fund Manager (EFM)
status.

• However Boutique asset management houses are not entitled to such treatments as the
criteria for qualifying under the AFM scheme is biased against start-ups and alternative
investment professionals

• This impedes the formation of a critical mass of asset management professionals who might
otherwise base their operations here

Relaxation in Regulations

• As fund management companies are exposed to lower risks than securities companies, they
generally need less capital. The criteria for obtaining a Capital Market Services (CMS) license
were too high, thus keeping smaller but well-managed fund management companies of

good repute out of Singapore.

• The MAS has relaxed the financial requirements to qualify for a CMS license without
compromising the prudential standards to safeguard investor’s capital. The minimum
amount of shareholder’s fund required for a CMS license for a boutique fund manager has
been lowered from S$500 million to S$100 million. Likewise, the minimum amount for global
funds management (other than boutique fund management) has been reduced from S$5
billion to S$1 billion.

• Outplacement of Government Investment Corporation (GIC) funds to private fund managers
would encourage the influx of professional talents into Singapore and help nurture the
finance professionals locally. Under the mandate, fund managers are expected to bring in
funds of their own to manage in Singapore, which would help deepen the liquidity of the
markets. The GIC has made substantial progress in placing out funds,

DIFC- MIGA Guarantee Program

The DIFC-MIGA Political Risk Guarantee Program is a joint programme undertaken by the Dubai
International Financial Centre (DIFC) and the Multilateral Investment Guarantee Agency (MIGA) of
the World Bank to support foreign financing in the MENA region through mitigation of political risk.

The programme is driven by the Dubai International Financial Centre’s (DIFC) objective of promoting
economic growth and development in the region, and MIGA’s mandate of promoting foreign direct
investment (FDI) in emerging markets. A survey conducted by MIGA in 2009 confirmed that political
risk and the economic environment were the biggest constraints for investing in emerging markets.
Due to these concerns, the majority of capital flows go to a handful of countries, leaving the world’s
emerging economies largely ignored.

The DIFC MIGA Programme addresses these concerns by offering risk insurance that helps foreign
enterprises manage and mitigate political, non-commercial risks when setting up businesses, starting
projects and investing in the region. For examples of Political Risk Guarantee please visit the case
studies section.

TYPES OF COVERAGE

Expropriation

Protects against losses arising from government actions that may reduce or eliminate ownership of,
control over, or rights to the insured investment. In addition to outright nationalisation and
confiscation, "creeping" expropriation — a series of acts that, over time, have an expropriatory
effect — is also covered.

Currency convertibility and transfer restriction

Protects against losses arising from an investor’s inability to legally convert local currency (capital,
interest, principal, profits, royalties, and other remittances) into foreign exchange and transfer local
currency or foreign exchange outside the country due to government action or failure to act.
Currency depreciation is not covered.

War terrorism and civil disturbance

Protects against loss from, damage to, or the destruction or disappearance of, tangible assets or
total business interruption (the total inability to conduct operations essential to a project’s overall
financial viability) caused by politically motivated acts of war or civil disturbance in the country,
including revolution, insurrection, coups d'état, sabotage, and terrorism. Protection may be

extended to situations when an investor is forced to abandon a project and assets are not damaged.

Breach of contract/arbitrage award default

Protects against losses arising from the government’s breach or repudiation of a contract with the
investor and non-enforcement of an arbitration award. Breach of contract coverage may be
extended to the contractual obligations of state-owned enterprises in certain circumstances. In the
event of an alleged breach or repudiation, the investor should invoke a dispute resolution
mechanism set out in the underlying contract and obtain a final arbitral award or judicial decision for
damages. If, after a specified period of time, the investor has not received payment under the
award, MIGA will pay compensation.

Non-honouring of sovereign financial obligations

Protects against losses resulting from a government’s failure to make a payment when due under an
unconditional financial payment obligation or guarantee given in favor of a project that otherwise
meets all of MIGA’s normal requirements.

For more information on new products offered by MIGA, please refer to the flyer below.

TYPES OF INVESTMENTS COVERED

The types of foreign investments that the DIFC MIGA Programme can cover include:

1. Equity
2. Shareholder loans
3. Loan guarantees
4. Non-shareholder loans (i.e. loans from financial institutions)
5. Non-equity direct investment
6. Other forms of investment, such as technical assistance and management contracts, asset

securitisations, bonds & Sukuk, leasing, services, franchising and licensing agreements, may also
be eligible for coverage.

COVERAGE AMOUNT

For equity investments, MIGA can guarantee up to 90 percent of the investment, plus up to an
additional 50 percent of the investment contribution to cover earnings attributable to and retained
in the project.

For loans and loan guaranties, MIGA generally offers up to 95 percent of the principal (or higher as
determined on a case-by-case basis), plus up to an additional 150 percent of the principal to cover
interest that accrues over the term of the loan.

COVERAGE PERIOD

MIGA typically provides coverage for a minimum of three years and a maximum of up to 15 years.
Islamic Finance

In addition to traditional financial transactions, the guarantees can also be structured to cover
Islamic Finance transactions. Accordingly, the guarantees can be used to enhance the overall
creditworthiness of various types of Islamic finance structures, including equities, bonds (both

conventional bonds and Sukuks), asset securitisations and project finance transactions.

Guarantees can be issued using “Shariah-friendly” contract wording

Guarantees can accommodate the complex back-to-back instrument nature of an Islamic project
finance structure (e.g. Musharaka - Istisna’a - Ijara Financing Structure)

Transfer Restriction cover can result in credit rating boost for cross-border Sukuk security issues

War and Civil Disturbance Damage risk cover perfectly suited to address political violence risk to
‘quasi’-owned assets of the Islamic Financier

Coverage can address specific political risks to Islamic hedging instruments (e.g. profit rate swaps)

CAPITAL MARKETS

Capital markets are increasingly being used to finance companies and projects, and to securitise in
the MENA region. For local companies and banks, the challenge of raising funds through capital
markets is one that pervades in many regional countries. Local companies may want to have access
to international markets that often have better terms: cheaper, longer-term funds, with a greater
and more diverse pool of investors. However, the company’s rating may be constrained by the risk
perception of the country, which puts a cap on the rating of the bond issue.

The DIFC MIGA Programme may be able to offer political risk insurance to the bondholders, thereby
improving the issue’s rating, increasing the pool of investors, and lowering the cost of the issue. DIFC
and MIGA are working closely with Nasdaq Dubai on promoting growth of capital markets through
bond and securitisation guarantees.

THIRD PARTY INSURANCE

The DIFC MIGA Programme also facilitates the participation of public or private insurers as
co/reinsurers or other providers of syndication.

SEBI (International Financial Services Centres) Guidelines, 2015

 Indian as well as foreign stock exchanges, clearing corporations and depositories are permitted
to set up subsidiaries to undertake the same business in IFSC subject to certain relaxed norms on
shareholding and net worth

 For instance, a stock exchange can be set up with Rupees 25 crore capital, as against the normal
requirement of Rupees 100 crore

 Initial capital requirement for a clearing corporation will be Rupees 50 crore, as against the
current norm of Rupees 300 crore

 Stock exchanges are also permitted to set up clearing corporations in IFSC.

 SEBI registered intermediaries or recognized intermediaries of foreign jurisdiction are permitted
to operate as securities market intermediaries in IFSC through a subsidiary or joint venture company

 The guidelines permits issue of depository receipts and debt securities in IFSC by domestic as
well as foreign companies

 The guidelines also provide for listing and trading of equity shares issued by companies
incorporated outside India, depository receipts, debt securities, currency and interest rate
derivatives, index based derivatives and such other securities as may be specified by SEBI from time

to time.

 Non Resident Indian, foreign investors, institutional investors, and Resident Indian eligible
under FEMA may participate in IFSC.

 Mutual Funds and Alternative Investment Funds set up in IFSC can invest in securities listed in
IFSC, securities issued by companies incorporated in IFSC and securities issued by foreign issuers.

Conversion of Debt into Equity by the Banks and Financial Institutions:

 Relaxation in certain provisions of the SEBI Regulations in cases of conversion of debt into
equity of listed borrowers

Issue and Listing of Debt Securities by Municipality:

 The proposed regulations provide framework governing the issuance and listing of bonds by
Municipalities

 Only revenue bonds can be issued in a public issue

 Issuers’ contribution for each project shall not fall short of 20 per cent of the project costs,
which shall be contributed from their internal resources or grants

 Mandatory credit rating, which needs to be investment grade rating in case of public
issuances.

 Minimum tenure of 3 years

Amendment to SEBI (Mutual Funds) Regulations, 1996, regarding managing/ advising of
offshore pooled funds by local fund managers

 As per current requirement a domestic fund manager can manage an offshore fund, only if,
(i) the investment objective and asset allocation of the domestic scheme and the offshore
fund are same, (ii) at least 70 % of the portfolio is replicated across both the domestic
scheme and the offshore fund, and (iii) the offshore fund should be broad-based i.e., there
should be at least 20 investors with no single investor holding more than 25 % of corpus of
the fund, etc. Otherwise, a separate fund manager needs to be appointed for an offshore
fund

 The Board has decided to remove the aforesaid restrictions for managing offshore funds,
belonging to Category-I FPIs and appropriately regulated broad-based Category-II FPIs, by a
local fund manager who is managing a domestic scheme

 SEBI’s proposal is well-intended and would help domestic fund houses manage greater
foreign capital

Review of Continuous Disclosure Requirements for Listed Entities:

 A listed entity shall disclose all events/ information, first to stock exchange(s), as soon as
reasonably practicable and not later than 24 hours of occurrence of event/ information

 The outcome of board meetings shall be disclosed within 30 minutes of the closure of the
meeting of Board of Directors

 The listed entity shall disclose on its website all material events/ information and such

information shall be hosted for a minimum period of 5 years and thereafter as per the
archival policy of the listed entity, as disclosed on its website

 Besides just providing USD and local currency loans, IFC can also facilitate clients’ access to
capital markets through:

 Providing credit enhancement through partial credit guarantees;

 Other different forms of credit enhancements: Anchor investing, Shadow underwriting

Recommendations

1. IFSC should go for a single stock exchange, as multiple stock exchange will lead to higher
cost of listing and competition. It will help the fund management companies in maintaining
their cost and for the investors to track their investments.

2. Safety Net should be made compulsory in terms of retail customers to safeguards their
rights and encourage financial discipline and high standards

3. MIGA Regulations should be adopted as being done in Dubai IFC to encourage and attract
foreign investors and companies to setup their base in India and increase their investments
in India

4. To attract fund managers in IFSC, government should give control of fund management to
companies setting funds in Indian IFSC. For example: The part of NPS that has to be invested
in equities can be handed over to these companies. This will act as a good incentive for the
companies to set funds in India.

5. IFSC should offer least cost of setting up offices and institution in comparison to world IFCs
through minimal taxes and relaxation in regulations in setting up of offices of Asset
management companies in terms of minimum amount of capital/net worth required. This
would attract more firms to set up their offices in Gift City

6. Non Institutional Investors should be given some tax incentives in terms of deductions to
invest in IFC’s capital markets or equity funds to increase the assets under management for
the AMCs in Gift City.

7. Liquid Investments:
Raise money through bonds for onshore and offshore investments. Keep the rating
threshold as AA-/Aa2 so as to hold government bonds and those from the state owned
banks. This will reduce the risk factor. IFC can issue bonds in local currency and use it for
new investments there e.g. issue bonds in Renminbi and utilize it for Chinese investments
through banks situated in China – Onshore investment. Also, issue bonds in rupees and
invest it in Chinese market through exchanging it for Renminbi – Offshore investment.
Example of London IFC: London is increasingly focussing on more issuance from Asian
market to leverage on investments in emerging economies like India and China. The deal has
2 pronged structure. London IFC issues masala bond raising 3.15 billion rupees with a 6.45%
coupon rate. This is an offshore bond denominated in rupees. Then those proceeds were
invested in Yes Bank’s 3.15 billion rupees onshore transaction, which came shortly
afterwards and carries an 8.95% coupon rate, leading to spread differential gain.

Price Discovery Mechanism

The following paper seeks to clarify the role of different components related to the price discovery
mechanism for the purpose of GIFT.

The price discovery process (also called price discovery mechanism) is the process of determining the
price of an asset in the marketplace through the interactions of buyers and sellers.

Importance of Liquidity in the Market for Efficient Price-Discovery

Liquid markets are generally perceived as desirable because of the multiple benefits they offer,
including improved allocation and information efficiency. Market participants perceive a financial
asset as liquid, if they can quickly sell large amounts of the asset without adversely affecting its price.
Liquid financial assets are thus characterized by having small transaction costs; easy trading and
timely settlement; and large trades having only limited impact on the market price.

Liquid markets tend to exhibit five characteristics: (i) tightness; (ii) immediacy; (iii) depth; (iv)
breadth; and (v) resiliency. Tightness refers to low transaction costs, such as the difference between
buy and sell prices, like the bid-ask spreads in quote-driven markets, as well as implicit costs.
Immediacy represents the speed with which orders can be executed and, in this context also, settled,
and thus reflects, among other things, the efficiency of the trading, clearing, and settlement systems.
Depth refers to the existence of abundant orders, either actual or easily uncovered of potential buyers
and sellers, both above and below the price at which a security now trades. Breadth means that orders
are both numerous and large in volume with minimal impact on prices. Resiliency is a characteristic of
markets in which new orders flow quickly to correct order imbalances, which tend to move prices
away from what is warranted by fundamentals.

A distinction is also made between the primary market, where new issues are sold, and the secondary
market, where those who have bought the issues at the primary market can resell them. The secondary
market thus provides liquidity to those who have bought the securities.

In relation to the GIFT, the regulatory authorities must hence, ensure, low transaction costs, efficient
and quick trading, clearing and settlement systems to ensure tightness and immediacy in the market as
well as the other factors. In addition, a simple registration process will help increasing the order and
lot size helping the market develop characteristics of breadth, depth and resiliency. However, the
latter three will gradually develop over the long run. Liquidity needs to be ensured in the market to
enable efficient price discovery for securities.

Significance of the Futures Market for Price Discovery

Considering the information exchange and price discovery roles of the futures market, many
theoretical as well as empirical attempts have been made and the regulatory bodies, market
makers, academicians and practitioners unanimously have agreed upon the common notion
that organized futures markets contain significant information for the prospective cash market
price changes in short-run, irrespective of the fact that in the long-run, both markets observe
strong and stable co-movement. One explanation to mispricing between two price series (cash
and futures) may be the immaturity of arbitrage sector to connect two markets.

 Possible reasons for persistence of large spreads over the period may be the presence of

imperfect market microstructure settings and the purpose for which futures contracts
are used. For instance; Beaulieu et al., (2003) observed that reduction in tick size of TSE
35 Index Participation Units from 0.60% to 0.25% of the prevailing price helped to
improve its price discovery efficiency in Canada, which implies that improvements in
contract specifications help to improve the price discovery efficiency of the asset.

 Jiang et al., (2001) found that contemporaneous relationship between futures and cash
markets got strengthened with removal of short selling restrictions in the Hong Kong
cash market particularly when the market was undergoing bear phase and the
underlying asset was relatively overpriced.

 Absence of tax implications and the ability of traders to short sell are important features
of the foreign exchange market, which enables currency futures to represent their
fundamental values.

 Also due to restrictions on the participation of foreign institutional investors in futures
market (which lead to lesser competitiveness in the market), information asymmetry in
Spain significantly increased after the introduction of futures trading. Therefore,
presence of artificial trading restrictions may make arbitrageurs handicapped to correct
price deviations between two markets,

 Significant relationship exists between mispricing and time-to expiry of the contract. It
is found that arbitrage opportunities are positively associated with time-to-expiry and
as soon as contracts approach near to the expiration date, mispricing disappear or if
were available, these were not economically exploitable. It is found that individual days
of one week to expiry do not show different mispricing patterns in India. NIFTY futures
were generally under-priced, therefore, as soon as the date of expiry approaches,
mispricing go down partially because squaring up of short positions by hedgers creates
sufficient demand of long positions in the futures market, which is reflected through
shedding of open interest positions about one week prior to the expiry of futures
contracts in India. Since, as on the date of expiry, uncertainty about expected dividend
yield goes away; therefore, prices of futures contracts closely reflect the prices of
underlying asset.

Hence, the prices of securities in the futures market significantly affect the underlying asset
values. In India the futures market does exist, even though it might not be as developed.
However, this interdependency between the two has to be taken into account for regulation of
arbitrage and for the comprehension of price discovery in the spot market. Additionally, this
section brings forth the fact that regulations should allow short-selling (discussed in detail
later), not have complicated tax regimes or artificial trading restrictions on any market
participant to ensure efficient pricing of assets.

Importance of Efficient Information Dissemination between Market
Participants and its Handling

The thrust of informational efficiency of securities markets is to alleviate and at the limit to
completely remove information asymmetries (an economic term that refers to the varying
quality of the information possessed by economic actors) between the investing community and
the issuers of financial instruments on the one hand, and between different classes of market
participants on the other hand. The rationale is that asymmetric information-along with
changing liquidity needs-establishes a motive for trade by some individuals, frequently leading
to costs borne by a larger community. With respect to these negative

externalities asymmetric information appears to be a particularly vexing and costly problem.
The purpose of removing this impediment can be better served through accurate, reliable,
timely and comprehensive disclosure of value-relevant information.

A general definition of informational efficiency holds that security prices, on average, instantly
and on an unbiased fashion reflect all available information about the future prospects of
issuing companies. The process of making relevant information available to investors therefore
appears to be of paramount interest. This can be done by the regulatory authorities in the
following manner:

 Informational accuracy of clearing prices- Clearing prices may significantly deviate from
equilibrium prices. As a consequence, the accuracy of price discovery becomes crucial for the
operational efficiency of securities market. For this purpose an efficient clearing and
settlement process is necessary.

 Dynamic efficiency of information dissemination- Two dimensions are of interest: 1) the
sequential order in which new information is made available to investors and, 2) the time
needed for information to be fully impounded into prices. Many markets have in-built circuit
breakers into the system which ensure that dissemination of information does not lead to
distortions in pricing and significant deviations from equilibrium prices in a short span of
time. Trading systems in which trading in a financial instrument is stopped when order
imbalances are high (so-called circuit breakers) tend to reduce price continuity. Circuit
breakers do so by allowing prices to move discretely after the pause in trading. However, the
halting of trades does not impact liquidity but may be needed to foster fair markets by
allowing all market participants to attempt to determine whether fundamentally new
information has altered an asset's equilibrium price. In this case, one would say that the
market has temporarily lost price continuity. However, when trading resumes at a new price
among informed traders, the market may still be a qualified as liquid In other words, traders
neutralizing small price deviations may no longer be around to help provide depth and
breadth, but the market may still be liquid and resilient thanks to more informed traders, as
the new information has already been absorbed.

In conclusion, it is necessary that all information within the market is efficiently and timely
disseminated to its member participants and some of the ways in which this can be achieved is a
timely and accurate clearing process as well as the mechanism of circuit-breakers inbuilt into the
system.

Impact of Short-Selling on Price Determination

What is short selling?

Short-selling is the selling of borrowed shares by investors who expect to cover their positions
later by repurchasing the shares at a lower price.

How is short selling beneficial?

 Accelerating price corrections in overvalued securities or accommodate[ing] abnormal
buying pressure which would otherwise over inflate a security’s price

 Specific to the UK market, market making and intermediary liquidity provision has
traditionally played a central part in the UK market structure. Any attempt to restrict the
freedom of liquidity providers to go short would make that role impossible. Prohibiting short
selling would prevent market makers satisfying customer buy orders except out of inventory

 Provide greater liquidity to the securities and derivatives markets

Whenever any economy (global or national) goes through a depression phase and securities markets
crash, regulators generally put a temporary or permanent ban on short selling. The prime reason given
for such a move is to protect the market from crashing. The 2001 and 2008 economic crisis saw the
US and UK regulators prohibiting short selling on some or all stocks. The Chinese government, after
the steep decline of its stock markets in Sep, 2015 also imposed such a ban on short selling. Currently
in India, short selling is permitted only for retail investors and large volume institutional investors are
not allowed to short sell securities. With a secondary research, this paper has attempted to analyze the
effect of short selling on market movement and compare the practices prevalent in a few international
markets.

Battalio, Mehran, and Schultz (2012) in their research evaluated the impact of ban on short selling in
the US markets. Short-sellers claim that by identifying overvalued stocks and correcting the
mispricing, they provide a valuable service to investors. For example, short-seller James Chanos,
founder of Kynikos Associates, a private investment management company specializing in short-
selling, reported that his firm looked for companies that appeared to have materially overstated
earnings, that had been victims of a flawed business plan, or that had been engaged in outright fraud.
According to him, months before actual surfacing of the Enron scam, he had started short selling on
the stock.

Apart from depriving the traders, investors and brokers from a mechanism to transact in the market,
ban on short selling has other costs associated with it. Boehmer, Jones, and Zhang (2009) found that
the 2008 short-sale ban in the United States was associated with a 32 basis point increase, on average,
in relative effective bid-ask spreads for the banned stocks. For the 404 financial stocks that were
subject to the ban for its duration—September 18 through October 8, 2008—the increase in spreads
represents an increase in liquidity costs of more than $600 million
Together, the inflated costs of liquidity attributable to the short sale ban in U.S. equity and options
markets were estimated to exceed $1 billion. This estimate ignores the lost gains from those trades
that would have been made had bid-ask spreads been at or close to normal levels. The estimate also
ignores the costs imposed on other markets. For example, convertible-bond arbitrageurs purchase
more than 75 percent of primary issues of convertible debt (Choi et al. 2010) and hedge their
purchases by shorting shares of stock. When the short-sale ban was imposed, the market for
convertible bonds dried up.

Matthew Cliftonab and Mark Snape (2008) analyze the impact of short sale ban on the London Stock
Exchange. As a result of the ban, trades and volume fell by approximately 10% in banned stocks
subsequent to the ban, while in control stocks the number of trades and share volume actually
increased by 50%. Also, turnover in banned stocks fell by 21% after the ban compared to a rise in
turnover of 42% in the control stocks.
Results suggest that banned stocks in the post-ban period have lower liquidity compared to the control
sample.

The concerns of regulators that short-selling can artificially drive prices below fundamental values is
valid to a certain extent, however profit making via this strategy is not easy.
Short sales may depress stock prices, but the short-seller profits only after buying back the shares at
low prices to close the position. If purchases and sales have a symmetric impact, such that a sale of
shares moves prices down by about the same amount as the purchase of the same number of shares
would raise prices, prices will rise to their original levels when the short-seller buys back the shares.
In that case, the short-seller will not profit from this strategy and will instead lose money on trading
costs.

One way for a short-seller to make a profit shorting an adequately priced is to somehow fool other
investors into selling him the shares at a price that is lower than the one he charged the original
investors. If the short-seller succeeds in moving prices below fundamental values and investors catch

on to his game before he repurchases the shares to cover his short position, the short seller can suffer
substantial losses as investors drive up share prices. Moreover, if short-sellers spread false rumors
about a company or attempt to manipulate its share price, they are engaging in illegal activities and
the targeted company may fight back. Such moves are very risky and may prove unprofitable.

A valid concern of regulators is a way in which a short-seller can profit from shorting a stock that is
correctly priced by weakening investor confidence in the firms whose stocks are shorted. Financial
firms whose soundness has been called into question in this way might be required by counterparties
to post additional or higher-quality collateral. They might even find that other companies have
decided to stop lending securities to them or trading with them altogether. Of course, this would be an
efficient outcome—and one that limits systemic risk—if the stock price of such a firm was low
because the business was unsound. But if the stock price was driven to artificially low levels because
of short-selling, the outcome would be an adverse one. However, this does not call for an umbrella
ban on short selling and these concerns can be mitigated via efficient checks and transparent
accounting and reporting practices.

Some major regulatory committees have favored such a move. The International Organization of
Securities Commissions (IOSCO) has also reviewed short selling and securities lending practices
across markets and has recommended transparency of short selling, rather than prohibit it.
Practices followed by the US in short selling can be referred to while determining the validity of short
sale. In the US, the then existing regulations allowed relatively unrestricted short selling in an
advancing market while preventing short sellers from accelerating a declining market. The regulation
used tick-test, a formula for defining price for permissible as well as non-permissible short-selling.
The defined price automatically takes into account the prevailing market condition. It permits short
selling at (i) a price above the price at which the immediately preceding sale was effected (plus tick),
or (ii) the last sale price if it is higher than the last different price (zero plus tick). Every short-sale
transaction needed to be disclosed upfront to the dealing broker who is held responsible for ensuring
that the transaction does not violate the tick test. All this meant that short-selling cannot take place
surreptitiously in US. Further, regulation did not require the regulators to prove short-seller’s intent or
motive. However, the tick test could only work in a quote driven system as in the US which relies on
the market maker, and not on an order driven market as in India.

In the Hong Kong Financial Centre, short selling is permitted in certain designated securities, like
those that were part of the benchmark indices or those in which futures and options have been made
available, in which the seller has the unconditional right to vest the security in the purchaser by virtue
of securities borrowing and lending agreement or has confirmation from the counterparty that the
counterparty has the security available to lend to him. Further, the tick rule has been specified, i.e., it
cannot be effected below the best current ask price. At the time of inputting the order, the HKSFC
requires the investors to communicate to the broker dealers that it is a short selling transaction.

Therefore, it is concluded that short selling is a legitimate investment activity that plays an important
role in supporting efficient markets and that significant changes to the existing regulatory regime were
not warranted. However, it recognized that increased transparency surrounding short selling would be
helpful, as long as the information provided would be useful and its benefits would outweigh any
disadvantages, i.e. that it should be useful; should not be overly burdensome to produce; and should
not unduly breach commercial confidentiality.

Case Study: Singapore’s Value Proposition as a Financial Centre

Monetary Authority of Singapore (MAS) has been closely studying trends in global finance and fine
tuning its strategies to develop Singapore as a premier financial center.

Debt capital market

In a world of deleveraging and higher regulatory constraints on banks, it is now more urgent than ever
to develop strong capital markets to complement bank lending and help to provide a better match for
longer term funding requirements.

The fundamentals for a strong debt capital market are in place:
 The Singapore bond market is fully accessible to all issuers and investors globally with no
capital controls, hedging restrictions, or withholding taxes.
 There is diversity of issuers - financial institutions, corporations and government agencies.
 There is variety in instruments issued, including structured and securitized debt.

Three other initiatives were announced to further improve the efficiency and liquidity of the
Singapore Dollar bond markets.

 The provision of swap liquidity to primary dealer banks handling Singapore Dollar debt
issuance for corporations is fully operational. MAS is now able to support swap transactions
at market-determined rates.

 The Singapore Dollar corporate bond securities lending facility has become operational. The
facility will provide market makers an avenue to borrow securities and make prices more
freely.

 The price discovery initiative to provide end-of-day prices for Singapore Dollar corporate
bonds has been completed. This price transparency has already spurred industry-led efforts
to create a Singapore Dollar corporate bond index which market participants could use as a
benchmark for investment management.

Innovations related to infrastructure
 SGX AsiaClear, Asia’s first OTC clearing facility, was established as early as 2006.
 As counterparty to both buyers and sellers, AsiaClear mitigates counterparty credit risk in
OTC transactions.
 AsiaClear’s value to the trading community extends to record and statement services, position
netting, and cost savings for customers posting margins.
 Today, SGX AsiaClear is the region’s leading multi-asset OTC clearing house, with volumes
exceeding 300 billion US dollars to-date.

Conclusion

Several relevant components related to the price discovery mechanism have been discussed in his
paper. Relevant recommendations with respect to the GIFT initiative have been provided in each
section.



IFC Regulatory Framework

Financial Regime Governance: i.e. the framework of laws, rules and regulations
governing financial products/services (and the way in which authorised regulatory
institutions specify, apply and enforce them) is therefore intrinsic to the value of
financial services in a way that governance is not intrinsic to the value of a car or a
ball bearing.

Financial regulation is thus an intrinsic, inseparable component of any financial
service/product; whether it is sold domestically or internationally. But, when sold
internationally, the regulatory component of that financial service/product must
conform to the best international norms/practices for it to be acceptable to global
markets and the financial firms and players operating in them. This is a key
premise that must be appreciated at policy making levels.

Some of the indicators that could be used to measure the financial regulation in
India could be of ensuing systemic ability, the task of avoiding crises that engulf the
financial system and the macro-economy at large. One part of this concerns the
protection of the integrity and soundness of financial institutions. But equally,
recognising that firm failure is an inherent feature and a learning mechanism in any
market economy, a sound regulatory regime has effective coping mechanisms when
market and institutional failures do take place so that failures are handled in a manner
that does not induce panic. A sound regulatory regime is one where good quality risk
management occurs at the level of firms, markets and the system at large. Failures to
achieve this can arise from faulty rules, in a rules-based regulatory environment, or
from moral hazard with finance firms which believe they will be bailed out in distress.

Another key test of a sound regulatory regime is whether it assures consumer
protection. What matters is the degree of genuine protection that consumers get as
opposed to a regime that is strong on rhetoric about the importance of consumers
while failing to uphold the interests of the consumer in reality.

One of the strongest tools for consumer protection is competition policy. A sound
regulatory regime is one in which there is full and effective competition and where
every market is genuinely contestable.

The next question is that of a level playing field. It is related to competition policy. It
seeks identical regulatory treatment of all firms. A key feature of an IFC is the
treatment of foreign firms. One indicator is the extent of protectionism embedded in
the regulatory system. This seeks to measure the treatment of foreign firms in a broad
sense. It is like a level playing field question where a domestic firm is compared
against a foreign firm.

A key indicator affecting the performance of the regulatory system is the problem of
conflicts-of-interest. Financial regulators tasked with various functions in financial
regulation need to have clear goals that do not conflict with each other . For example,
around the world, an increasing number of monetary authorities are tasked with
achieving the single goal of price stability. Separate institutions undertake regulation
and supervision of the financial system.

But, in India, in addition to the core goals of monetary policy, the central bank as a
regulator has other subsidiary roles. These include: protecting banks, enabling the
provision of subsidised credit in some sectors, running a bond exchange and a
depository, and financing the public deficit at lower than real market cost. Can a
central bank that: is not constitutionally independent of government, has multiple
roles, and is asked to achieve multiple non- monetary goals, possibly avoid multiple

conflicts-of-interest from arising on a day- to-day basis? Can it do so when the
government that is its apex authority, is also the country’s largest owner of banks,
owns other financial firms and is its largest borrower?

In the globally competitive game of, innovation is the main source of competitive
advantage. The impact of the regulatory regime on financial innovation directly
affects success in establishing an IFC. This issue is also related to the extent of
regulatory intrusiveness and micro-management of markets and institutions. It is
inimical to succeeding in the global competition for IFC.

Though India does not have an IFC, India’s legal system is widely perceived as
adhering in principle to the rule of law, underpinned by a time-tested constitution and
a durable, resilient legislative democracy that has been time-tested for six decades. At
its apex, India is perceived as having a paradoxical combination of: (a) world-class
knowledge, competence and sagacity about global finance, reposed in a few
accomplished individuals with technocratic backgrounds and relevant practical
experience; coupled with (b) a lack of similar knowledge, and ideological opposition,
at other levels as to how the global economy and financial system function.

The legal system – in terms of its ability to understand and deal with issues of inter-
national finance – is perceived as capable at the apex level, but weaker at intermediate
and lower levels. The legal system in India/Mumbai is perceived by practitioners
abroad as adequate by international standards but not as knowledgeable about global
finance simply because it has not had the opportunity to acquire such expertise. The
absence of recognised global legal firms in India, with specific expertise and
experience in dealing with IFC, provides some cause for concern. That deficit
represents a serious in- stitutional handicap if Dholera is to become an IFC.

Recommendations

1. Shift towards a more principle based regulation from the existing rule based
regulation. Although rule based regulation brings in security, it inhibits
innovation which is he key for the competitiveness of an IFC. PBR, already
being used in UK since 1997, nvolves less detailed prescription of what is
allowed and what is not in every activity or market, less codification, less
rigidity of rule- book interpretation, and a greater reliance on practice and
precedent.

2. The foundation of competition policy is a ceaseless process of creative
destruction, where every year, some financial firms fail and exit from the
business, while new financial firms enter into the business every year. This
ceaseless churning appears messy since newspaper headlines dwell on firm
failure. However, it is the only way to achieve a globally competitive financial
sector. Hence, an environment Conducive to exit must be created.

3. From an IFC’s perspective, almost all transactions are likely to be bigger than

Rs. 100 million. Hence, a rapid pace of innovation in wholesale markets is

quite consistent with a focus on export of IFS. But this approach has an
important downside, in the context of organised arms-length financial markets,
where secondary market liquidity is formed by pooling millions of orders,
small and large. The fragmentation of liquidity between segregated retail and
wholesale markets would reduce liquidity. India’s key strength – i.e., its vast
retail market – will not be able to play in areas where retail participation is
prevented. Hence, while this wholesale versus retail approach has merit in
some areas such as money management, there is a need of caution when it
comes to the securities markets, where unification of all orders into a single
order book yields maximum liquidity and thus international competitiveness.
4. India needs both exchange-traded derivatives and OTC derivatives. However,
these arguments suggest that particularly in the early years, a special focus
should be placed on obtaining world-class liquidity on the exchange platform.
This is where India’s IFS export opportunity lies, and this is the ‘raw material’
using which OTC derivatives are made. The right sequencing is to first have
a liquid electronic trading screen, after which an OTC market can spring
up based on utilisation of the prices and liquidity produced on this screen.
5. From an IFC perspective, the most useful strategy may be the creation of
specialised courts that combine (a) highly experienced arbitrators equipped
with specific IFC domain knowledge, and (b) streamlined workflow leading to
minimal delays. Extending the scope of the present Securities Appellate
Tribunal (SAT) might be a useful way of addressing these concerns. SAT
already has judicial capacity with specialised domain knowledge in securities
markets. It processes cases with obvious efficiency at an impressive pace.

Insurance Regulations

The Insurance Regulatory and Development Authority (IRDA) which is constituted
under the Insurance Regulatory and Development Authority Act 1999, and which
derives its powers from the Insurance Act 1938 regulates entities which carry on
insurance business and intermediary business (brokers, insurance surveyors, loss
assessors, insurance agents and third party administrators) in or from India.

Foreign direct investment to the extent of 49 per cent of equity share capital of an
Indian insurance company and insurance sector intermediaries has now been permitted
under extant Indian laws.
Foreign direct investments up to 26 per cent of the total paid up equity of the Indian
insurance company is allowed under the automatic route, i.e. without prior approval of
the Foreign Investment Promotion Board (FIPB).

In Life Insurance Bancassurance is contributing to nearly 50 percent of premium (in
the private players, LIC still relies on Agents).
In general Insurance too bancassurance plays a major contributing factor.

However currently the policy states banks will be allowed to tie up with only one Life
insurer and one general insurer.

There is a need for Open architecture if we need to increase to insurance penetration
in India which is quite low as compared to developed economies

The open architecture aims at increasing insurance penetration through optimal
utilisation of banks' infrastructure and experienced workforce.
However, for it to be successful, the regulator should allow the banks to tie up with at
least two non-life and two life insurers in each state. This will promote healthy
competition and allow the banks to offer a choice to their customers.

The open architecture could enable an insurance company to offer its products at any
branch of any bank across the country through multiple tie-ups. This will enlarge the
range of options available to potential insurance buyers by increasing insurance

penetration into geographies left untapped so far.

In South Korea and Hong kong the open architecture helped increase their premium
growth rates by roughly 50 percent also their penetration rates have increased.

According to the IRDA, there are certain regulations for the investments made in Insurance
companies.

1. Government Securities: - Not Less than 20 %
2. Central Government Securities and other approved: - Not less than 30%
(Including 1)
3. Investment subject to exposure norms
a) Housing: - Not less than 5%
b) Infrastructure: - Not less than 10%
4. Approved investments: - Not exceeding 55%

A large chunk of investments have to be made in government securities and thus the
profits to are very controlled.

In order to attract foreign investors we need to relax the above norms. Insurance
companies should be allowed to invest directly in stock.

1) Settlement Cycle

Trade confirmation
Trade confirmation between direct market participants should occur as soon as possible after trade
execution on the same day (i.e no later than trade date (T+0)). Whenever confirmation of trades by
indirect market participants is required, it should occur as early as possible after the trade execution,
preferably on T+0 (but no later than T+1).

Use of Straight through processing (STP)
STP can be achieved by allowing information that has been entered electronically in the system to be
transferred from one party to another in the settlement process without manually re-entering the
same information repeatedly as and when needed.
STP is essential for maintaining high settlement rates as volumes increase and also for ensuring
timely settlement of cross-border trades, particularly if reductions in settlement cycles are to be
achieved.
It helps in reducing the settlement risk by shortening the transaction-related processing times and

will also increase the probability that a contract or an agreement will be settled on time. The
automation involved improves processing time by eliminating the requirement to send information
back and forth manually among the various parties involved and by avoiding the errors inherent in
manual processing.

Settlement cycle

The longer the duration between trade execution and settlement process, the greater risk that one
of the parties may default on the trade or become insolvent. This would result in large number of
unsettled trades. Also, there is greater chance for the prices of the securities to move away from the
contract prices, thereby increasing the risk that the non-defaulting parties to incur a loss when
replacing the unsettled contracts.

Currently, in some markets, government securities settle on T+1 or even T+0, and some equity
markets are currently considering to improve to T+1 from T+2 settlement cycle. However, the actual
duration for a transaction in a given market for a given security will depend upon factors such as
transaction volume, price volatility and the extent of cross-border trading in the instrument.

In most markets, a move towards a shortened settlement cycle would require a substantial
reconfiguration of the existing trade settlement process and an upgradation of the existing systems.
Without such investments, a move to a shorter cycle could increase the settlement fails, with a
higher proportion of participants unwilling to agree and exchange settlement data or to acquire the
necessary resources for settlement in the time available. As a consequence, replacement cost risk
would not be reduced as much as anticipated and operational risk and liquidity risk could increase.

Fee structure

The following are the fees charged by IFCs in Dubai and Hongkong. As can be seen from the table,
they do not charge anything for clearing and charge for trading and settlement as a proportion of
the volume involved, subject to a minimum value.

Fee Type Dubai IFC Hong Kong IFC

Trading Fee 0.05% on executed order value 0.13 USD
(minimum USD 5) + USD 3 per
executed order

Clearing Fee NIL NIL

Central Securities 0.05% on executed order value 0.002% of gross value of an Exchange

Depository (minimum USD 3) trade, subject to a minimum fee of

/Settlement Fee 0.26 USD and maximum of 13 USD

Timings for IFC
Leveraging the time difference advantage between various IFCs:
Dubai IFC functioning time: 8:00am to 3:30pm (Dubai local time)

Time lag between India and Dubai: India is 1.5 hrs ahead of Dubai

 So, if Indian IFC starts at 8:00am, it gets additional 1.5 hours to attract traffic from Dubai IFC.

Singapore IFC functioning timings: 9:00 am to 5:00pm (Singapore local time)

Time lag between India and Singapore: Singapore is 3.0 hrs ahead of India.

 As Singapore is ahead of India, there can’t be any advantage in the morning.
 In the evening, the closing time for Singapore IFC is 5.00pm i.e. 2:30pm in India.
 If Indian IFC is functioning till 5:00pm , for 2.5hrs Singapore traffic will be directed to Indian

IFC
 If Indian IFC is opened till 6:00pm in the evening, by then both Dubai and Singapore will be

closed.
o For 2.5 hrs Singapore traffic will be directed to Indian IFC
o For 1.0hr , both Dubai and Singapore traffic will be directed to Indian IFC

To leverage maximum benefits, the optimal functioning time of the IFC should be from 8:00 am to
06:00 pm.

2) Clearing should be cash or delivery settled?

A forward contact at expiration can be settled in any of the two ways. They are either cash settled or
physically delivered.

1. Physical Delivery – It requires the actual underlying asset to be delivered on the specified
delivery date. Most derivatives are not actually exercised, but are traded out before their
delivery dates. Even then, physical delivery still occurs with some trades. It is most common
with commodities, but can also occur with other financial instruments.

Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly
after the last day of trading, the exchange's clearing organization reports a purchase and
sale of the underlying asset at the previous day's settlement price. Traders who hold a short
position in a physically settled security futures contract to expiration are required to make
delivery of the underlying asset. Traders who do not own assets are obligated to purchase
them at the current price.

The exchange does not set the settlement prices. The settlement price of the physically
delivered futures energy contracts is decided during the last 30 minutes of trading on the
final trading day, and that price is used to determine margin calls and invoice prices for
deliveries.

The exchanges specify the conditions of delivery for the contracts they cover like acceptable
locations for delivery, quality requirement, grade, etc. In many commodity or energy
markets, parties want to settle futures by delivery, but exchange rules are too restrictive for
their needs. For example, the New York Mercantile Exchange requires that natural gas be

delivered only at the Henry Hub in Louisiana, a location that may not be convenient for all
futures traders.

Best practice for all traders is to be out two trading days before FND (First Notice Day). This
way if there are any out trades or errors, they still have a full trading day to get any issues
fixed before FND.

If a trader wants to deliver or take delivery of a commodity, they will coordinate with their
broker, the clearing firm and the exchange in order to do so. If the trader does not want to
take delivery, they can be offered the option to Retender.

Retender: If a trader is long and assigned delivery, they may elect to “retender” the
commodity. They will also have to sell the futures contract. When the retender process is
complete, the assigned delivery will offset with the short futures contract. The exchange
typically charts a fee for retendering.

2. Cash Settlement – A settlement method used in certain future and option contracts
whereby, upon expiry or exercise, the seller of the financial instrument does not deliver the
actual but transfers the associated cash position.

It requires the counterparties to the contract to net out the cash difference in the value of
their positions. The appropriate party receives the cash difference. In the case of cash
settlement, no actual assets are delivered at the expiration of a futures contract. Instead,
traders must settle any open positions by making or receiving a cash payment based on the
difference between the final settlement price and the previous day's settlement price.

Cash settlement is useful and often preferred because it eliminates much of the transaction
costs that would otherwise be incurred when physically delivering a good. Because the costs
associated with cash settled contracts are lower, it appeals to both hedgers and speculators.
Cash settlement also helps reduce credit risk for futures contracts.

In contrast, the cash settled contracts settle on a futures price on the fourth business day
before the 25th, hence the name “penultimate,” and never go to delivery.

And for smaller traders, when a cash settled contract expires, they needn’t worry about final
settlement or the extra fees associated with exiting the position. And if a trader is not in the
business he doesn’t have to worry about carry charges or having the physical wherewithal to
process or store the physical goods.

Analysis
 As the commodities markets become more democratized through the use of electronic
trading, it becomes more efficient for a wider base of traders and funds.
 For a trader, the important differences are not so much the settlement methods, but rather
the liquidity and the transaction costs.
 A futures contract that calls for physical delivery may not result in actual delivery itself.
Many traders would buy or sell futures contracts prior to the delivery date to realize their
profits or loses. These are typically speculators who are in for the money and have no

intention of taking actual delivery.
 On the last day of trading, physically settled contracts will typically experience thin liquidity,

as those traders who do not intend to convert their futures contracts to physical goods have
already exited the market either rolling their position to the next delivery month or simply
getting out. So, traders with large positions have more affect on price movements and this
can subject the market to more intense volatility as it heads towards expiration. Large
commercial traders who have the physical wherewithal to take or make delivery may even
possess storehouses of the physical commodity.
 Thus, IFC should focus its efforts more on the physically delivered futures markets. By
requiring large traders to disclose their positions on a regular basis, IFC can make certain
that that market concentration doesn’t lead to price manipulation in the monthly settlement
at expiration.
 Because the cash-settled contracts settle before the physically settled contracts, they have
less exposure to large traders pushing the contract around as it nears settlement. And,
because financially-settled contracts are frequently settled against indexes or against
settlement data derived from a variety of sources, they are widely believed to be less prone
to price manipulation than are physically- settled futures contracts.

3) Clearing and Settlement Risk Mitigation:

This section explains the various types of risks involved in the clearing and settlement process and
the mechanisms which are followed by IFCs and exchanges around the world to mitigate those risks.
We also recommend these mechanisms to be implemented in the IFC in the GIFT city.

In a rolling settlement system the time gap between the trading date and the final settlement
creates settlement risk. There are 3 major types of settlement risk

 Principal risk: Loss of principal on a transaction, either from the funds or the securities side
 Replacement cost risk: Replacement cost of a security is the price at which a trade can be

replaced in the market if the original transaction goes into default. The buyer of security
faces this risk if there is a price increase after default and conversely the seller faces this risk
if there is a price decline after default. Longer the settlement cycle greater will be the
replacement cost risk.
 Liquidity risk: It occurs because of the lack of funds or securities in one of the party’s
account at the time of settlement, however the transaction may be settled in full at a later
point of time. It occurs mainly because of operational reasons such as funds deposited in the
wrong account of a broker’s settlement bank.

Most of the exchanges follow DVP (Delivery Versus Payment) mechanism in order to mitigate the
principal risk. However replacement cost risk and liquidity risk are not mitigated through DVP
mechanism. So the CCP must specify a loss sharing mechanism by which the losses initially borne by the
DVP agent is allocated across various participants in the settlement system. The loss sharing mechanism
can be through

 Combination of shareholder equity
 Pay-In capital fund
 Soft-capital insurance policies

 Pro rata sharing of losses by participants

Below are some of the measures taken by Hong Kong IFC to mitigate the settlement risks:

 Brokers check the availability of securities or cash with the custodian or settlement bank
before executing the trades and in case of insufficient holdings the trade is rejected. Once
the trade is executed the traders are binding on the brokers. In case of overdraft, interest
penalty is imposed based on the amount of overdraft and securities are held as collateral

 Settlement reserve fund: Each security company/ investor has to maintain a minimum
balance in its cash settlement account which will be decided by the central counterparty
(CCP)

 Settlement guarantee fund:Settlement guarantee fund is financed by the settlement

participants according to a formula set by the clearing and settlement institution, which is used
to cover losses incurred by settlement participants that do not meet their delivery or payment
obligations
 Securities settlement risk fund: Which is used to cover any unavoidable losses for the CSD
resulting from settlement failures, technical incidents or operational errors. This fund is
initially funded with 20% of the net revenue/profit of the CSD and further funded according to
a certain ratio of the overall equity, fund, bond and repo trading volume of the settlement
participants. The upper limit of the fund is currently set at RMB 3 billion
 Auto Collateralisation: Where credit is provided to settle a security transaction which is
secured by means of collateral (securities already purchased or being purchased)

Below are some of the risk mitigation mechanisms that are followed across the major IFCs

 Capital Requirement: The CCP can specify the minimum level of capital to be maintained by
the participating firms thus mitigating credit risk. Also they can create a guarantee fund as
mentioned above in order to provide temporary liquidity and to absorb and allocate losses across
brokers. In addition to these there can be soft capital facilities, which are owner backed
guarantees. Such facilities pay off only in the event of actual default.

 Collateral Requirements: Most of the IFCs follow multilateral netting mechanism by which
multiple funds or securities transfer obligations between brokers are offset. Some of the
transactions fail because of net debit in securities or funds account when the settlement
instruction is issued. So the CCP can extend credit against collateral (underlying securities or
purchased securities) in order to promote liquidity and to reduce the number of failed
transactions.

 Position and Debit Limits: Position limits are directed at securities transaction level and make
sure that firms do not accumulate positions that may end unsettled. Net debit limits are
intended to prevent CCPs from incurring large intra-day or overnight obligations either in
securities or funds.

Measuring the Risks: In order to measure risk properly the CCP must first define the risk horizon
which depends on the settlement cycle. It is important to have an estimate of current exposures of all
unsettled transactions and also the same day liquidity and principal risk of transactions due to settle
that day. Some of the risk measurement techniques used are value at risk (VAR), below target risk,
below target probability, downside semi-variance.

Buy-in/ Sell-out rules: Also some of the IFCs such as London have buy-in and sell out rules. In case of
default by a seller, the buyer “buys-in” the stock from another seller and the original seller has to pay the

difference if the new purchase price is higher than the original price. The buy-in will not be applicable if

 the liable party is not a member of the exchange
 an attempt to buy-in by the exchange would have a significant market impact
 the exchange is unable to source the security concerned
 Gilt-edged securities

Continuous linked settlement:

Continuous linked settlement (CLS) is a settlement system for foreign exchange trades that is used to
eliminate settlement risk. It is run by the CLS Bank International, which is a special purpose bank
dedicated to settling foreign exchange trades.

All the transactions are settled through the CLS Bank during a single 5-hour window each business day.
The transactions are settled on a payment versus payment (PVP) basis. Each party delivers the
currency it owes to the CLS Bank. That payment will not be released to the counterparty unless that
counterparty deposits the offsetting payment for the transaction. Multilateral netting allows each
participant in the continuous linked settlement to make just one net payment per currency on each day.

The Settlement Service:

 Mitigates Forex settlement risk in the world’s single largest market

 Settles payment instructions relating to transactions in 17 currencies and executed in the
following instruments: FX spot, FX forward, FX swap and OTC credit derivatives

 Is available directly (Settlement Members) or indirectly (through Settlement Members providing
access to third parties) to Forex marketparticipants

Management of Trade Arbitrage

Arbitrage Mutual Fund

Arbitrage Mutual Funds offers relative value volatility arbitrage fund with a stated focus of
delivering optimal, consistent "risk-adjusted" investment returns uncorrelated to general
market movements and trends by exploiting pricing anomalies between Asian Pacific stocks
and related exchange traded derivative contracts.

Why need to develop it?

Asia is dominated by long/short hedge funds, which do apply hedging techniques but typically
hedge apples with oranges. We hedge apples with apples and are looking for pricing
anomalies, not studying/screening balance sheets to look for absolute or relative stock out-
performance. We are capturing Alpha, not creating it and there is no one else in Asia
adopting this trading strategy or possibly even with the experience to execute it.

The reason why Asia is having high opportunities are because short-term liquidity is high, due
to the issuance of covered warrants in Hong Kong, and the large and increasing retail activity
generally across the Asian markets. In addition dividend yields are high and dividend growth
is strong and above average in many blue chip companies in Hong Kong, Australia and Asia.
As institutional and retail interest continues to return to the Asian markets, we expect the
opportunities to continue to increase.

Strategy should be designed to take advantage of relative value differences in implied
volatilities between say an index and a basket of component stocks. This strategy is
uncorrelated to the markets' direction and more a function of retail liquidity.

Different type of arbitrage opportunities in Asia are:

 Index Arbitrage,
 Warrant Arbitrage,
 Stock Class Arbitrage,
 Convertible Bond Arbitrage,
 Option Arbitrage,
 Dispersion

Currently Arbitrage funds from Hong Kong don’t participate much in Indian market because
of low liquidity in Derivatives market compared to other markets like Hong Kong, Korea and
Japan etc.

Hong Kong Market the funds analysed by us is Accudo Asian Value Arbitrage of SinoPac
One of

Asset Management.

JPM Global Merger Arbitrage: To provide a return in excess of its cash benchmark by taking
advantage of the deal risk premium factored into the price of companies which are, or may
become, involved in merger activity, takeovers, tender offers and other corporate activities
anywhere in the world, using financial derivative instruments where appropriate.

Asset Allocation Breakdown:

Asset % of Fund
Class (30-Jun-2015)

US Equities 65.60
UK Equities 11.70
European Equities 11.60
International Equities 3.40
Canadian Equities 3.40
Australian Equities 2.70
Swiss Equities 1.20
Japanese Equities 0.40

Regional Breakdown: % of Fund
(31-Jul-2015)
Region
64.10
USA 12.90
UK 11.80
Europe 3.90
Canada 3.30
Others 2.10
Australia 1.30
Switzerland 0.60
Japan

Let us look at some event-driven strategies through liquid alternative funds. These funds
provide transparency, liquidity, and low investment minimums.

Below are the mutual fund options:

The arbitrage fund- The Arbitrage Fund, seeks capital growth through an investment
approach focused on the strategy of merger arbitrage. This fund invests in companies being
acquired in publicly announced mergers and acquisitions. The strategy’s goal is to capture the
difference, or spread, between the price of the target company’s stock and the price offered
for these securities by the acquiring company. The approach seeks to deliver consistent,
positive absolute returns with lower volatility and low correlation relative to the broader
markets.

RISKS: The Funds use investment techniques with risks that are different from the risks
ordinarily associated with debt and equity investments. Such techniques and strategies
include merger arbitrage risks, high portfolio turnover risks, options risks, borrowing risks,
short sale risks, non-diversification risks, and foreign investment risks. The Arbitrage Event-
Driven Fund and The Arbitrage Credit Opportunities Fund also include credit risks, interest
rate risks, interest rate swap risks, credit default swap risks, and convertible security risks.
Risks may increase volatility and may increase costs and lower performance.

Arbitrage Event-Driven Fund - The Arbitrage Event-Driven Fund, launched in 2010, seeks
capital growth through an opportunistic and flexible approach to event-driven investing. This
multi-strategy fund invests in the equity and debt instruments of companies involved in
corporate events. Here, our investment team employs multiple investment strategies such as
merger arbitrage, convertible arbitrage, and capital structure arbitrage. Our approach seeks
to deliver consistent, positive absolute returns with lower volatility and low correlation
relative to the broader markets.

RISKS: The Funds use investment techniques with risks that are different from the risks
ordinarily associated with debt and equity investments. Such techniques and strategies
include merger arbitrage risks, high portfolio turnover risks, options risks, borrowing risks,
short sale risks, non-diversification risks, and foreign investment risks. The Arbitrage Event-
Driven Fund and The Arbitrage Credit Opportunities Fund also include credit risks, interest
rate risks, interest rate swap risks, credit default swap risks, and convertible security risks.
Risks may increase volatility and may increase costs and lower performance.

Arbitrage Credit Opportunities Fund - The Arbitrage Credit Opportunities Fund, launched in

2012, pursues a non-traditional, catalyst-driven approach to fixed income investing. Our
alternative credit-based strategy focuses on a broad range of catalysts and events, such as
mergers, refinancings, deep value credit, and regulatory changes through investments in
bonds, bank loans, convertibles, and preferred stocks. The fund holds both long and short
investments, and may employ convertible arbitrage, merger arbitrage, or capital structure
arbitrage techniques in an attempt to exploit security mispricings or inefficiencies. This
unconstrained bond fund seeks income and capital growth, targeting returns that are more
correlated to the outcomes of specific catalysts or events rather than to overall market
direction or interest rates.

RISKS:The Funds use investment techniques with risks that are different from the risks

ordinarily associated with debt and equity investments. Such techniques and strategies

include merger arbitrage risks, high portfolio turnover risks, options risks, borrowing risks,

short sale risks, non-diversification risks, and foreign investment risks. The

Arbitrage Event-Driven Fund and The Arbitrage Credit Opportunities Fund also include credit
risks, interest rate risks, interest rate swap risks, credit default swap risks, and convertible
security risks. Risks may increase volatility and may increase costs and lower performance.

Supporting Theory – Interest Rate Parity

Interest rate parity takes on two distinctive forms: uncovered interest rate parity refers to the
parity condition in which exposure to foreign exchange risk (unanticipated changes in
exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in
which a forward contract has been used to cover (eliminate exposure to) exchange rate risk.
Each form of the parity condition demonstrates a unique relationship with implications for
the forecasting of future exchange rates: the forward exchange rate and the future spot
exchange rate.

1.1 Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes
on the interest rate differential between two countries by using a forward contract to
cover (eliminate exposure to) exchange rate risk. Using forward contracts enables
arbitrageurs such as individual investors or banks to make use of the forward premium
(or discount) to earn a riskless profit from discrepancies between two countries' interest
rates. The opportunity to earn riskless profits arises from the reality that the interest
rate parity condition does not constantly hold. When spot and forward exchange rate
markets are not in a state of equilibrium, investors will no longer be indifferent among
the available interest rates in two countries and will invest in whichever currency offers a
higher rate of return.

1.2 An arbitrageur executes an uncovered interest arbitrage strategy by exchanging domestic
currency for foreign currency at the current spot exchange rate, then investing the
foreign currency at the foreign interest rate, and at the end of the investment term using
the spot foreign exchange market to convert back to the original currency. The risk arises
from the fact that the future spot exchange rate for the currencies is not known with
certainty when the strategy is chosen.

Trends in Regulation
The UK is now ahead of the US in terms of its regulatory approaches, attitudes and practices.
The rules-based regulation of the US faces severe competition from the principles-based
regulation of the UK. That competition is being worked out in the global marketplace as
country after country opts for the UK model.

Products used for Arbitrage
It is important to note that pricing of derivative products needs to happen correctly. This was
seen in the case KCBT (Kansas City Board of Trade) index after T. H. Eytan and G. Harpaz
wrote a paper in Journal of Finance titled “The Pricing of Futures and Options Contracts on
the Value Line Index”. The index swung back from a positive spread in the futures price to
spot price to a negative basis.

Dubai IFC
Lists Dubai Mercantile Exchange products on CME Globex:Listing the DME (Dubai Mercantile
Exchange) Oman Crude Oil Futures Contract and the DME Oman Crude Oil Financial Contract
(ZG) on CME Globex will further increase opportunities for improved risk management by
Asian refiners through sophisticated hedging strategies, as well as creating arbitrage
opportunities and other advanced trading strategies for the trading community around the
world.

CME Globex is an electronic trading platform through which users worldwide are able to
access the broadest array of the most liquid financial derivatives markets available anywhere.

DIFC also has companies that seek to exploit arbitrage opportunities, through extensive use
of data analytics. E.g. Robert Half.

REIT – Dubai IFC

REIT stands for Real Estate Investment Trust which is a type of collective investment scheme or put
more simply a special type of Property Fund.

 Create a new market for high value property assets
 Developers can sell property but, through investment management role, continue to control

and benefit from property management functions with minimal investor interference
 Funds and REITs are medium to long term investors which can bring stability to the property

market

Advantages of a REIT ?

• A REIT allows retail investors to acquire an interest in a diverse range of income producing
property assets without loss of liquidity.

• This decreases risks involved in a single property purchase and allows investors to invest passively
in a professionally managed property portfolio.

Characteristics of DIFC REIT

General:

• Can use corporate or trust fund structure

• Must be closed ended (i.e. no redemption during term of the Fund).

• Fund Manager must be regulated by DFSA or recognised financial services regulator with
equivalent regulation

• New regulations allow for flexibility in relation to ownership and financing arrangements –
particularly important for Shariah compliant REITs