Trading Derivatives in Malaysia: Overview and Methods

1. 2 Chapter Malaysian Derivative Markets and Trading

2. This Chapter discusses the trading of derivatives in Malaysia, provides an overview of the Malaysian Exchange and examines the trading methods/mechanism. On completing this Chapter, you should have a good understanding of Malaysian derivative instruments, their trading methods and mechanisms. Chapter Objective

3. Derivative instruments may be either exchange traded or traded Over-The-Counter (OTC). Futures and Options are mostly exchange traded whereas Forwards and Swaps are largely OTC traded. Unlike exchange trading where the contracts are standardized and governed by formal rules/trading procedures, Over-The-Counter (OTC) markets are informal markets that, have negotiable arrangements and customized contracts. Introduction

4. Exchange trading through standardized contracts has several big advantages like efficient price discovery, increased liquidity, reduced transaction costs and easy price dissemination, but there are some shortcomings. Most of these shortcomings arise from the standardization of exchange traded contracts. The ability to negotiate and customize contracts to tailor-fit one’s needs with regards to size and maturity is often the biggest advantage of OTC markets. Transaction costs on OTC markets are generally higher. OTC instruments are also usually less liquid and susceptible to counterparty risk.

5. The Open-Outcry or Auction Method: Trading is done in a trading hall by means of shouting out orders and by the use of hand signals. The Computerized or Screen Based Method: Trading is done by means of a distributed computer system. Buy and Sell orders are entered directly into the system with the computer playing match maker. Trading Methods

6. Comparison of Trading Methods

7. Currently, Malaysia has a single derivatives exchange known as Bursa Malaysia Derivatives Berhad or BMDB. Prior to the demutualization of Bursa Malaysia, BMDB used to be known as MDEX (Malaysia Derivatives Exchange). This new exchange which began on 11th June 2001 was the result of a merger by Malaysia’s two previous derivatives exchanges COMMEX and KLOFFE. Though COMMEX was the older of the two, KLOFFE was the exchange that introduced Malaysia’s first financial derivative. Malaysian Derivative Contracts and Exchange

8. COMMEX which was the result of a 1998 merger of two exchanges had its beginnings in the Kuala Lumpur Commodity Exchange (KLCE). The KLCE which was Malaysia’s first derivative exchange was established in 1980. As the name suggests, the KLCE was established to introduce and trade commodity derivatives. The first derivative contract introduced by the exchange was the Crude Palm Oil (CPO) futures contract in 1980. Commodity and Monetary Exchange of Malaysia : COMMEX

9. KLOFFE, Malaysia’s first financial derivatives exchange was established in July 1993 by a consortium of private companies. This first product was a Stock Index Futures contract based on a revamped KLCI (Kuala Lumpur Composite Index). With the introduction of this index futures contract, KLOFFE became the second derivative exchange in Asia, after Hong Kong, to trade its own equity derivative. Exactly five years later on 1st December, 2000, KLOFFE introduced its second product, index options. The KLCI Options as they are known, have call and put options of varying strike prices available for investors. The Kuala Lumpur Options and Financial Futures Exchange (KLOFFE)

10. BMDB is currently the country’s one derivatives exchange. Today, BMDB trades a total of 9 derivative contracts. Of the nine, seven are financial derivatives while the remainder two are commodity contracts. The seven financial contracts are: 1. KLCI Stock Index Futures (FKLI) 2. KLCI Index Options (OKLI) 3. Single Stock Futures (SSFs) 4. 3 month KLIBOR futures (FKB3) 5. 3 year MGS Futures (FMG3) 6. 5 year MGS Futures (FMG5) 7. 10 year MGS Futures (FMGA) Bursa Malaysia Derivatives Berhad (BMDB)

11. Plays two key roles – Record keeping and – Risk Management Bursa Malaysia Derivatives Clearing Bhd (BMDB)

12. By means of the “novation principle” the clearinghouse imposes itself as the intermediary in every transaction done through the exchange and sent to it for registration. In essence, the clearinghouse substitutes itself as the buyer to seller and the seller to every buyer. This substitution by the clearinghouse is a key facility in enhancing liquidity since it enables buyers and sellers to enter and exit markets easily. Since the clearinghouse upon registration of the trade, guarantees the transaction, customers eliminate their counterparty risk.

13. The Bursa Malaysia Derivatives Clearing Bhd (BMDCB) is the sole clearinghouse for both financial and commodity derivatives. Until Prior to Bursa Malaysia’s demutualization, BMDCB used to be as MDCH, Malaysia Derivatives Clearinghouse. Originally established in 1995 to handle financial derivatives, MDCH was restructured in 1997 to handle both financial and commodity derivatives.

14. The objective of regulation is always to ensure fair and transparent markets by enforcing ethical behavior on the part of all players. The regulatory framework for the financial derivatives market in Malaysia is embodied in the Futures Industry Act; FIA (1993). Derivatives Regulation in Malaysia

15. TABLE 2.2 Derivatives : Regulatory Structure • approves exchanges • appoints three directors of the exchange • Appoints Executive Chairman Of Exchange Futures Industry Act (1993) FIA MINISTRY OF FINANCE SECURITIES COMMISSION • oversee regulation of operations • relevant licensing • enforcement of FIA Bursa Malaysia Bhd Bursa Malaysia Derivatives Berhad Bursa Malaysia Derivatives Clearing Berhad Source : BURSAMALAYSIA

16. Figure 2.1: Total Monthly Volume and Month End Open Interest (Bursa Malaysia Derivatives-All Derivatives) Source: Based on data from Bursa Malaysia Website

17. Table 2.3: Sample of Derivatives Exchanges Ranked by Traded Volume Source : Futures Industry Association (FIA) www.futuresindustry.org

18. Key Terms