HOW TECHNOLOGY IS SHAPING THE DERIVATIVE MARKET

Introduction

The derivative market is a keystone of global finance promoting the practice of hedging, price discovery and risk management for a number of assets and liabilities. Over time, variations in the market dynamics, technical advancements, and regulatory measures have all contributed to a substantial transformation of the derivative markets across the globe.

Simply put - A Derivative refers to a class of financial instruments that derive their value from the price and various other related variables of an underlying asset bearing no value of its own individually. An elementary example of how a derivative works would be to determine the price of butter, which in turn is determined by the price of milk and hence butter is the derivative of milk.

Global Derivatives Market

The global derivatives market is a trillion dollar industry estimated to be valued over a quadrillion in notional value with the latest data from the Bank for International Settlements (BIS) over-the-counter (OTC) derivatives statistics showing a sharp rise in the notional outstanding of OTC derivatives by 7.9% by the end of 2023 in comparison to the end of 2022, driven by growth in interest rate and foreign exchange derivatives.

Indian Derivatives Market

The history of the Indian derivatives market from its inception to the present weighs significant turning points, legislative actions, and market advancements that have influenced the nation's derivatives trading environment. Indian derivatives markets have been in existence from as early as 1875, when The Bombay Cotton Trade Association introduced futures trading by way of dealing in the commodities market.

The Securities Laws (Amendment) Ordinance that was incorporated in 1995 marked the commencement towards the implementation of financial derivatives trading in India which was later upheld by Securities Exchange Board of India (SEBI's) ultimate clearance in May 2000.

Between April 2022 and March 2024, the exchange-traded currency derivative (ETCD) market saw an average monthly turnover of Rs 1.51 lakh crores. The primary contributors of this are transactions from the proprietary trading desks of financial institutions and individual investors. ?A staggering 99.6% of trading activity on the Indian stock market is comprised of equity derivatives, with daily volumes surpassing $4.3 trillion which amounts to a whopping 125% of the market capitalization of the underlying companies or over 200% of all free float traded in the market signalling that derivatives are traded at 1.25 times the total market capitalization of the Indian stock market on a daily basis. Currently, the volume of derivatives is 400 times higher than cash equities and 900 times more than delivery-based trading volumes. The Over the Counter (OTC) derivatives industry is growing rapidly with the notional value hovering around the $9.27 trillion ballpark making it the 20th largest OTC derivatives market worldwide.

As per Financial Express, the upsurge of online trading platforms and ubiquitous use of smartphones have made derivatives trading more accessible. New contract structures and leverage options, along with user-friendly trading apps, have transfigured the industry. Consequently, the number of active derivatives traders has seen an exponential hike from under half a million in 2019 to over 4 million now, marking almost close to an eight-fold increase. In contrast, the cash market has seen its participants grow from around 3 million in 2019 to 11 million in the present times.???????????????????????????

?In the rapidly advancing landscape of financial markets, a recent Securities and Exchange Board of India (SEBI) study highlighted a striking analysis which revealed that nearly 91% of the individual traders are fighting a losing battle, not just against market volatility, but against a latent combatant which are the transaction costs.

On further analysis, this inordinate financial outcome was attributed to the rise of algorithmic trading, with 97% of the Foreign Portfolio Investors (FPIs) and 96% of Proprietary Traders generating massive amounts of profits through the use of advanced trading algorithms which exacerbates the profit gap and also impedes the fairness in the functioning of ?the market, resulting in a system where majority of the market participants incur losses while a handful of the participants reap size-able profits. Actions like these raise fundamental questions about the viability and the neutrality of the present trading ecosystem.

The convolutedness of the current system can be discerned to the market’s evolution over the past few decades. Widely incorporated to provide hedging opportunities and to enhance market efficiency, the derivatives segment is intertwined in a circuitous web of intermediaries, including brokers, clearing houses and depositories. While these entities were originally brought into the system to ensure adequate market stability and transparency, its aggregate charges have created a financial obstacle that looks seemingly arduous to overcome.

As one of the most dynamic and prominent sectors within the financial world, there is a persistent demand for trail-blazing platforms, technologies and software to accommodate the complexities and legal requirements of the derivative market.

The market infrastructure for derivatives faces a wide range of challenges. Regulation has contributed to significant improvements in post-trade processes. Still, a proliferation of disparate unstandardized legal and transaction data and an over-dependence on costly, manual intervention across operations obstruct the progress. These issues, coupled with various regulatory uncertainties require greater focus on a standard industry blueprint for a simplified post-trade process.

Given this background, it is critical to examine whether technological innovations and advancements can disrupt the status quo. Can a more transparent, neutral, accessible and cost-effective market be envisaged? The time is ripe for a technological revolution to tackle the issue.

Role of Technology in the Derivatives Market

Recent developments in financial technology have unfolded new possibilities for better market infrastructure. One particularly promising channel of growth is the concept of digital asset representation. At its very core, digital asset technology enables the creation of tokenised representations of traditional financial assets. Complex assets become divisible, democratizing access to high value investments. Rules, rights and obligations can be embedded into the assets, creating programmable financial instruments.

From cloud-based transaction data to algorithmic trading, innovations and advancements in technology continue to solve the problems that pose as challenges in this rapidly evolving landscape.

?The Financial Stability Board defines Fin-tech? as “technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions, and the provision of financial services.”

Financial Technologies provides innovative solutions to facilitate the integration of financial services offered by financial institutions.

·?????? Valuation

Artificial Intelligence (AI) has displaced many traditional techniques that were used to value derivatives such as the Monte Carlo simulation which can be computationally demanding and requires significant time to produce results.

Innovations in the field of Machine Learning and AI have overcome many of these challenges, enabling calculations to be performed in a one-tenth of the time, relieving pressure on systems, and providing for greater accuracy of valuations thereby expediting the process of decision-making.

·?????? Data Analysis

Progress in data analytics technology has aided traders significantly to ameliorate their ability to assess and manage risks. With artificial intelligence (AI) and machine learning enabling vast amounts of data to be analyzed at high speed and precision, traders can spot patterns and anomalies with greater accuracy, enhancing their ability to assess potential risks in the market.

This technology can empower traders in harnessing data to gain meaningful insights from large and varied data sources such as market prices, trading volumes and economic indicators, enabling them to assess and adjust their exposure to risk and make more informed and strategic decisions. Cloud-based solutions also play a crucial role in assisting the derivatives market.

·?????? Smart Contracts

A smart legal contract is a legally enforceable contract in which some or all of the contractual obligations are performed automatically by a computer program. It is capable of being executed immediately leading to reduction in delays and errors associated with the human processing of contracts. The terms of the contract can also be automatically adjusted and updated if necessary.

The International Swaps and Derivatives Association (ISDA) has issued a Common Domain Model (CDM) which is a standardized solution aimed at providing market participants with a common digital representation throughout the life-cycle of a derivatives transaction.

·?????? Gen AI

The emergence of Gen AI seeks to improve the integration of existing data and documentation into universally acceptable data frameworks. It can also aid in responding to general queries from stakeholders on trade confirmations in natural language processing and understanding. AI shall also be used to promote regulatory compliance to detect anomalies in regulatory data.?

Conclusion

As organizations come under added pressure to increase efficiencies and reduce costs, higher standardization and automation will be fundamental to all transactions with ownership and transactions being monitored with complete transparency in real time.

The impact of technology on the derivatives industry is a compelling interaction between efficiency and transparency, on one side, and potential risks and challenges, on the other. Stakeholders should work together to harness the ?benefits of innovation while minimizing the related risks, fostering? collaboration to understand Fin-tech innovations, developing flexibility to adapt to the rapid technological changes in the derivatives market.

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