Derivatives Introduction 1

JPMC Spoofing Settlement

The CFTC and SEC have release separate orders which fines JPMorgan Chase and Company (JPMC) desks) for spoofing and manipulation of markets - specifically the Treasury and Metals markets.

The CFTC order is filing and settling charges with JPMC and its subsidiaries. To quote

for manipulative and deceptive conduct and spoofing that spanned at least eight years and involved hundreds of thousands of spoof orders in precious metals and U.S. Treasury futures contracts on the Commodity Exchange, Inc., the New York Mercantile Exchange, and the Chicago Board of Trade "

JPMC is required to pay a fine of $920.2 million, split as restitution ($311.7 million; highest ever), disgorgement ($172 million) and civil monetary penalty ($436.4 million).

Parallelly, the Department of Justice’s Fraud Section and the United States Attorney’s Office have reached an agreement to defer criminal prosecution of JPMC on charges of wire fraud. The agreement requires JPMC to to pay a criminal fine, disgorgement, and restitution.

The SEC order files and settles charges against JPMS (JPM Treasury Desks) and levies disgorgement and a civil monetary penalty.

The CFTC order will recognize and offset any restitution and disgorgement payments made to the DOJ and the SEC.

Case background

Between 2008 through 2016, JPM, through numerous traders on its precious metals and Treasuries trading desks, placed orders to buy certain metal future contracts and Treasury bond futures contracts with the intent to cancel those orders prior to execution. These orders sent false signals of supply or demand designed to deceive market participants into executing against other orders they wanted filled..

.*An example cited in the SEC order, to quote

"For example, on May 20, 2015, JPMS Treasuries Desk Trader 1 placed a sell order for one (1) lot of the 30-Year Treasury Bond at a best ask price of $98.921875. After not being filled, the order was modified to a two (lot) limit order placed such that only an order of one (1) lot was publicly visible to other market participants (i.e., an “iceberg” order). When the order was still not filled approximately ten seconds later, the trader placed an opposing non-bona fide order to buy ten (10) lots of the same series of Treasury Bond at an above best bid price of $98.90625. One second later, the order to sell was executed at the favorable best ask price. Two seconds later, the trader canceled the non-bona fide buy order"

Several such events have been cited and monitored by the SEC

SEC order says that JPMS profited by executing buy orders for Treasury securities at lower prices, or sell orders for Treasury securities at higher prices, than it otherwise would have secured absent the JPMS Treasuries Desk Traders’ manipulative trading.

There is a history of this investigation and one can find this from WSJ articles (see this https://www.wsj.com/articles/justice-department-charges-three-traders-over-alleged-metals-contracts-manipulation-11568646947)

Interestingly enough these charges against the traders included racketeering which is usually applied in cases against organized entities (the RICO statute).

Links to the CFTC and SEC orders

https://www.cftc.gov/PressRoom/PressReleases/8260-20

https://www.sec.gov/litigation/admin/2020/33-10858.pdf

The Karvy Securities Issue

Introduction

Karvy Securities is a broker of securities on the NSE/BSE. Many of their clients having accounts with them have seen their shareholdings not accounted for in the depository (demat accounts) and/or have not received cash for sale done. This is being investigated by SEBI and related regulators.

This is a short note that explains the basics of the market structure and what happened. Details can be found in some other publications.

Background

Before we understand what happened to investors and their holdings (and cash) held with Karvy securities, let us understand the institutions and account structure. 

Refer to Figure 1

·         A retail (or institutional client) executes trades (buy/sell) through a broker who is a member of the exchange.

·         The client holds an account with the broker which also includes a securities holding account called as the demat (dematerialization account).

·         These accounts are opened with the central depositories run by CDSL and NSDL. So, any stocks that you buy and once settled after you pay the stock balances are taken out or deposited into the client’s demat account.

·         The broker has control on the demat account via the Power of Attorney granted by the client when they open an account.

·         The broker also keeps an account of client transactions and this is what the end client sees when they login – this is the broker’s version of your account.

·         The actual account is held with CDSL or NSDL (the primary clearing houses for stocks in India and also the depository for stocks)

What happened?

What happened is Karvy, who has the client’s Power of Attorney, transferred your shares in the CDSL/NSDL account to other banks as a pledge (collateral) and borrowed money from them. This money was apparently given to their realty business. 

How is it that investors did not realize that their shares had been moved out? 

Because investors only (and usually) check their broker provided trading account. It appears what was shown to clients was incorrect and did not reflect the share balances (which were moved out) on the NSDL/CDSL.

This obviously is a breach of trust and possibly fraud. 

What should investors do to safeguard their stock accounts? 

1.    Reconcile their holding between their own records against the records held at CDSL/NSDL (R1)

2.    Check that after a trade (buy or sell), the CDSL/NSDL balances are updated to reflect the trade

3.    Check contract notes from the broker

4.    Check the notifications that come from NSE/BSE and CDSL/NSDL

How should one check the balances on CDSL/NSDL?

Create a login at CDSL/NSDL and check periodically that their purchases and other transaction affecting their share balance is correct and reflects their actual transactions.  

What about cash?

·         Cash is held by the broker and in an account held with the clearing house (run by CDSL/NSDL).

·         So again, check balances in the broker account and make sure it matches your own records.

·         Move out the balances held by the broker to your own bank account periodically especially if you hold significant cash balance.

·         It is easy these days to transfer money into your account held with your broker.

Any more queries or if you wish to get such notes, please send me an email at rshanx@gmail.com  

Thank you and good luck with investing!

TCS Buy Back

TCS has announced a share buy back at its board meeting on 20th Feb.

The board has approved a proposal to buyback up to ~5.61 crore shares for an amount not exceeding Rs 16,000 crores. The buyback price will be at Rs 2.850. The number of shares bought back will be 2.85% of the total paid-up capital.

Why do companies buy back their shares? Why TCS?

Companies can use their profits
1. Use for new capex / investments to grow the  business
This is done if the project returns gives an ROE that is near current levels

2. Pay out dividend
If no more cash is required after the capex/investments

3. Keep the cash and invest in money market instruments
Keep excess cash

As the cash pile increases, companies can pay out more dividend. Dividend is taxable before the payout (in India).

A share buyback is a market operation and signals to the market that the value of the company is more than the current market price and this is a way to pay out cash to the shareholders in a tax efficient way.

Shareholders can tender their shares through a broker. Only a proportion of shares will be accepted by TCS. This will be in proportion to their holding and the number of shares tendered to TCS.

For every 100 shared one holds, assuming all tender their shares, 2.85 shares will be purchased by TCS @ Rs 2850/-

For the shareholder, if Securities Transaction Tax is paid, there is no Long Term Capital Gains applicable if they have held the shares for more than one year.

Introduction to Financial Derivatives

A derivative is a financial instrument whose value is derived from another underlying asset. The underlying asset could be

• Stock
• Interest rate or foreign exchange rate
• Index value such as a stock index value
• Commodity price or index

Value of a derivative is ‘derived’ from another variable

The four basic derivatives types are

• Forwards
• Futures
• Options
• Swaps

A. Forwards

A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. On the specified date, the underlying asset will be received or delivered at this price.

• The seller of the forward contract has the right and obligation to sell the asset on the date for the price
• At the end of the forward contract, at “delivery,” ownership of the good is transferred and payment is made from the purchaser to the seller
• Generally, no money changes hands on the origination date of the forward contract
• However, collateral may be demanded

Delivery options may exist concerning the

• quality of the asset
• quantity of the asset
• delivery date
• delivery location

If your position has value, you face the risk that your counterparty will default.

B. Futures

This is a financial contract

• obligating the buyer
• to purchase an asset (or the seller to sell an asset),
• such as a physical commodity (crude oil, wheat, corn) or a financial instrument (debt instruments, stock index, currencies)
• at a predetermined future date
• at a predetermined future price

Futures contracts are standardised and are be traded on exchanges. Default risk is lower as they are cleared on exchanges.

Futures and Forwards are identical in structure. The key difference is

• Futures are exchange traded and hence have no counterparty risk, Forwards are OTC (Over the Counter) products
• Futures are standardized contracts (done by the Exchange), Forwards are customized by the parties.

C. Options

These are derivatives with the following features

The buyer of an option

• Has the right
• but not the obligation
• to buy (or sell) a particular product
• on a particular date (Exercise Date)
• at a particular price (Strike or Exercise Price)

The seller of the option

• Receives a premium for selling the right
• Has the obligation to deliver the product when the buyer exercises the option
• An option seller is also called a ‘WRITER’

Listed Options are standardised and are traded on exchanges

OTC Options are customized and not traded on exchanges

Call Options

• A call option is a contract that gives the owner of the call option the right, but not the obligation, to buy an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day
• The seller of a call option, the call writer, is obligated to deliver, or sell, the underlying asset at a fixed price, on (or sometimes before) expiration day
• The fixed price is called the strike price, or the exercise price.

Put Options

• A put option is a contract that gives the owner of the put option the right, but not the obligation, to sell an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day
• The seller of a put option, the put writer, is obligated to take delivery, or buy, the underlying asset at a fixed price, on (or sometimes before) expiration day.
• The fixed price is called the strike price, or the exercise price.

Options that can only be exercised at expiration are called “European” options.

Options that can be exercised any time until expiration are called “American” options

D. Swaps

• A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions
• Involves the exchange of cash flows arising from specific
• Assets
• Liabilities
• To exchange one set of cash flows for another without involving the transfer of the asset or liability itself
• A swap is like a portfolio of forwards. Each forward in a swap has a different delivery date, and the same forward price

Infosys’ Results – Quarter ending Dec 2014

 

Total Employees are 1,69,638 (at the end of this quarter)

Fixed Income Securities Basics – Structure

Happy New Year 2014 and Welcome to this blog. Hope you enjoy these posts and take away something from this.  Happy Journey.

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A fixed income instrument or a bond is a financial security that promises to pay a fixed income stream at fixed dates in the future.

Typically issued by governments, state agencies municipalities and corporations. When a corporation or government wants to borrow money, it often sells a bond to investors or lenders.
In structure a bond is the same as a loan.

Let us consider a basic bond. The borrower receives a principal amount from the investor for a fixed period of time.

The borrower promises the following to the investor:
1. Pay the regular interest or coupon payments every period till bond maturity. This rate of interest is fixed at the beginning and also called the coupon rate.

2. Repay the initial borrowed amount at maturity. Maturity is the end date of the borrowing period or term. The borrowed amount or principal is also called the face value of the bond (this would be the  amount shown on the bond certificate issued by the borrower to the investor or lender).
The bond structure can be represented by the below picture.



The above picture is a cash flow representation of the bond over its life. Such a representation makes it easier to understand a bond visually.

Key Points
1. On issue date, initial bond face value paid to issuer
2. On periodical intervals, regular interest or coupon payments are paid to the investor.
3. At maturity, bond face value is redeemed by issuer and paid to the investor

To summarize, a basic bond is characterized by the following:

• Maturity date
• Face, par or principal value
• Interest Rate (or Coupon Rate)
• Number of interest payments per year (typically 2; also called coupon payments)

Example of a Basic Coupon Bond
Bond Parameters:

1. Bond Face Value: $100,000
2. Bond Term: 5 years
3. Coupon Rate: 4%
4. Coupon Payment: Six Months (Semi-Annual)
5. Bond Issued on 15 March 2011 and will mature on 15 March 2016

Since the coupon rate is 4%, the annual interest will be
Annual Interest = 0.04 x 100,000 = 4000
Semi Annual Coupons will be half of 4000 = 2000

We will continue to look at more real life examples and understand more about the bond characteristics, issuance, risks and valuation.