1.

0 INTRODUCTION

More formally, a derivative is a financial contract between two parties to

transact an asset at a fixed price at a future date. The person selling the
contract is usually called the writer of the contract. The person buying yhe
contract is usually called the buyer of the contract. Both parties are called the
counter parties of each other. The buyer who holds the derivative contract is
said to have a long-position in the contract, while the seller who sold the
derivative contract is asaid to have a short-position in the contract. The
future date where cash flows would be exchanged is called the expiry date.
The asset to be transacted is called the underlying asset. The
transaction price of the asset, which is fixed up front when the derivative
contract is originated, is called the strike price of exercise price. That is the
basic definition of a derivative contract. As modern derivatives evolve in
sophistication, there are now derivatives that involve more than two parties,
allow the transaction of the underlying asset before the expiry date, and even
allow a varying strike price.
Besides, there are forwards, futures and options are probably the three
most common derivative instruments. As in the case of any other product,
derivative instruments involved as a result of product innovation. Innovation
which was in response to increasingly complex needs. As business
environments became increasingly sophisticated, new and better financial
products were needed to manage changed needs. The requirement that
every newly envolved product must provide increased benefits or value
added over existing products in order to survive applies equally to
derivatives.

2.0 MALAYSIAN DERIVATIVE

While most modern day derivatives are exchange traded, many are not .
Exchange traded means that the instrument is designed by, listed and traded
on a formal centralized exchange. Though most exchanges have a centralized
physical structure such as the Bursa Malaysia, increasingly exchanges are
becoming more electronic and virtual with minimal physical size. The LFX

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(Labuan International Exchange Inc. ) would be a good example of an
electronic exchange with minimal physical infrastructure. Thus, derivative
instruments may be either exchange traded or traded Over-the-Counter(OTC).

2.1 Trading Methods

Trading methods on derivative exchanges can be divided into two broad

categories. There are, i) The Open-Outcry or Auction Method and ii) The
Computerized or Screen based method. Though the Open-Outcry method of
trading has historically been the mainstay of exchanges, computerized
electronic trading is now fast gaining prominence. While the older exchanges,
like the Chicago and London exchanges, which have always had open-outcry
systems have been forced to also introduce electronic screen based systems,
the newer exchange are entirely screen based.

2.1.1 Open-Outcry/Auction Methods

Exchanges with open-outcry trading methods typically have huge trading

floors within which all trading takes place. The large trading floor is
subdivided into smaller areas known as pits or trading pits. Each trading pit is
designated to trade one derivative contract. Some contracts that are very
popular may have more than one pit assigned to its trading. In such a case,
different pits may trade the same contract but of different maturities.
Trading is done by means of shouting out orders and by use of hand
signals. A standard set of hand signals using the palm and figers are used. A
trader wanting to sell would signal his intention by facing his palm outwards
and the number of extended fingers signaling numerical prices. For examples,
the number two is represented by two vertically extended fingers whereas
two parallel (horizontally) pointed fingers would denote the number seven.
Both the numbers ten and zero are quoted by a closed fist. Finally, a buy
signal would be indicated by the palm faced backwards. The numerals for
number of contracts and prices are indicated by extended fingers.

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2.1.2 Order Routing/Trade Execution

A client who wants to trade derivatives would first call his futures broker
(usually a company), the broker representatives who takes the call,
processes the order and time stamps the order form before passing on the
information to the trading floor. On arrival at the company’s booth near the
trading floor, the order form is again time stamped before being delivered to
the respective trading pits by runners.
Depending on the structure and trading method used, an exchange
would have several categories of intermediaries for the execution of trade.
Some for example have Broker Members, Clearing Members, Non-Broker
Members, Locals and Trade affiliates.

2.1.3 Computerized/Screen Based Trading

The systems works by means of a distributed computer network. Customer

buy or sell orders, instead of being routed to a trading floor, are keyed in
directly into dedicated terminals in futures brokers offices. These terminals
are connected to a main frame CPU which acts as a matchmaker. The
terminals display the few best bid (buy) and offer (sell) prices.
For example, the current five highest bid prices and the five lowest
offer prices may be displayed at any one time. Once a bid price is equal or
higher than the lowest offer price, a transaction goes through.

2.1.4 Open-Outcry versus Computerized Systems

The open_outcry system does indeed have some shortcomings relative to

computerized systems. The most severe being that it is much error prone.
Errors in documentation, in communicating etc. have remainded a problem.
On the other hand, open-outcry systems have the advantage that they are
less prone to trading halts caused by order imbalances. While open-outcry
systems may be more adaptable at absorbing price jumps, computerized
systems appear to be less so and subject to trading halts.

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3.0 MALAYSIAN DERIVATIVE CONTRACTS AND EXCHANGE

Currently, Malaysia has a single derivatives exchange known as Bursa

Malaysia Derivative 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 11 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. For the sake of historical
perspective, the following two subsections provide a quick overview of
BMDB’s predecessors, COMMEX and KLOFFE.

3.1 Commodity and Monetary Exchange of Malaysia: COMMEX

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 1990.
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. Subsequent
to the successful launch of CPO futures, the KLCE introduced several other
commodity future contracts, which were:

• 1983 -Rubber futures contract (RSSI, Rubber Futures)

• 1986 -Rubber futures contract (SMR 20, Rubber Futures)
• 1987 -Tin Futures Contract
• 1988 -Cocoa Futures Contracts
• 1990 -Palm Olein Futures
• 1992 -Crude Palm Kernel Futures

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 Despite having introduced seven commodity futures contracts by mid-
1990, the originally introduced Crude Palm Oils futures contract remained the
mainstay COMMEX and of BMDB currently. The CPO contract is the most
actively traded contract and has been the key to the exchange’s survival.
This may in large part be due to the fact that unlike cocoa, tin and rubber
futures that are also traded in foreign exchanges in London, Tokyo etc, CPO
futures are only traded in Malaysia. As such, the CPO futures settlement
prices on BMDB are often used as reference prices in third party trade
elsewhere.
Though from a logistical viewpoint, the establishment of a new
subsidiary to trade financial derivatives made sense, the economic of the
situation did not. MME (Malaysian Monetary Exchange), could not continue on
its own with the single contract it had. In early 1998 at the urging of the
Ministry of Finance, the two exchanges worken on a ‘merger’. This resulted in
the KLCE absorbing MME in December 1998. The new entity came to be
known as COMMEX.

3.2 The Kuala Lumpur Options and Financial Futures Exchange

(KLOFFE)

KLOFFE, Malaysia’s first financial derivatives exchange was established in July

by a consortium of private companies. Though the conceptualization and
planning for KLOFFE had been completed in early 1990, the setting up of the
exchage had to be preceeded by the resolution of jurisdictional issues and
legislation. Jurisdiction was an issue since the existing derivatives exchange,
the KLCE was a commodities exchange under the Ministry of Primary
Industries.
A financial derivative contract would have to come under the Ministry
of Finance. In addition to working these jurisdictional issues, new legislation
was also needed to trade financial derivatives. With the resolution of these
issues, KLOFFE was able to introduce its first product on 15 December 1995.

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 The first product was a Stock Index Future contract based on a
revamped KLCI (Kuala Lumpur Compposite 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 1 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.
Despite an independent beginning, KLOFFE’s owner sold the exchange
to Bursa Malaysia’s predecessor the Kuala Lumpur Stock Exchange (KLSE) in
early 1999. For a time KLOFFE was a wholly-owned subsiadiary of the KLSE. In
December 2000, KLOFFE was merged with COMMEX to form MDEX. With the
merger, all derivatives trading in Malaysia was consolidated under a single
exchange, MDEX. Since MDEX itself was a wholly-owned subsidiary of KLSE,
KLSE became Malaysia’s single exchange, trading stocks and both commodity
and financial derivatives. With the demutualization of the KLSE and its re-
naming as Bursa Malaysia Berhad, MDEX was re-named Bursa Malaysia
Derivatives Berhad.

3.3 Bursa Malaysia Derivatives Berhad (BMDB)

As mentioned earlier, BMDB is currently the country’s only derivatives

exchange. Given its very recent establishment, its history is really that of
COMMEX and KLOFFE. Today, BMDB trades a total of nine derivative
contracts. Of the nine, seven are financial derivatives while the remainder
two are commodity contracts. The seven financial contracts are:

• KLCI Stock Index Futures (FKLI)

• KLCI Index Options (OKLI)
• Single Stock Future (SSF)
• 3-month KLIBOR futures (FKB3)
• 3-year MGS Futures (FMG3)
• 5-year MGS Futures (FMG5)
• 10-year MGS Futures (FMGA)

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 While the first three contracts are equity derivatives, the latter four are
interest rate derivatives. Single Stock Futures (SSF) are the most recent
addition, having been introduced in late April 2006. Of the nine total
derivative contracts on BMDB, the remainder two are commodity contracts:
the Crude Palm Oil futures contract and the Crude Palm Kernel Oil Futures.

With the establishment of BMDB, the evolutionary cycle of derivatives

exchanges in Malaysia has probably reached its final point. As late as 1998,
Malaysia had three derivative exchanges trading three contract. Economic
rationale has meant that following severals rounds of mergers, the country
now has one exchange offering all four existing contracts. Though fully
absorbed by Bursa, BMDB’s contracts are traded on a different platform and
require different licensing arragemet for stocks brokers to trade the
derivative contracts.

4.0 BURSA MALAYSIA DERIVATIVES CLEARING BHD (BMDCB)

The clearinghouse is a vital ingredient of any well functioning derivatives

market. As the name suggest, a clearinghouse has the main objective of
clearing trade. Simply put, clearing trades means identifying who has bought,
who has sold, what amount, who needs to deliver, to whom should delivery
be to, etc.
A clearinghouse’s functions can be broadly categorized into two basic
areas: (i)record keeping and (ii)risk management. In its first function as
record keeper, the clearinghouse registers all trades that takes place on the
exchange. When a customers does a trade, his broker has to clear the trade
with the clearinghouse. The broker does it directly if the broker is a clearing
member. Otherwise, the broker clears through another broker who must be a
clearing-member.
Thus, every transaction that takes place on an exchange ultimately
gets channeled for registration with the clearinghouse. Aside from being able
to record the positions taken by customers/traders, this activities constitutes
the basis on which the clearinghouse is able to carry out its second function;

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risk management. There are two levels of risks that the clearinghouse has to
manage. The first is the risk faced by the client/traders. Notice that when a
customers takes a long or short position, he or she is faced with counterparty
risk. That is, the risk that the other party to the transaction might default. By
means of the ‘novation principle’ the clearinghouse imposes itself as the
intermediary in every transaction done through the exchange and sent to it
registration. In essence, the clearinghouse substitutes itself as the buyer to
seller and the seller to every buyer. This substituition by the clearinghouse is
a key facility in enhancing liquidity since it enables buyers and sellers to
enter and exit market easily. Since the clearinghouse upon registration of the
trade, guarantees the transaction, customers eliminate their counterparty
risk.
Now that the clearinghouse has guaranteed every transaction, it has to
make sure that neither of the two parties to any derivatives transaction will
default. This is does by means of the margining and marking to market
process. Both the margining and novation processes are intended to ensure
the integrity of transactions, the clearinghouse however has to further ensure
the financial integrity of the intermediaries.
It should be obvious that given the heavy transaction processing,
clearinghouses would have high overheads. As such, unless there is sufficient
trading volume, it would not make sense to have more than one
clearinghouse. The Bursa Malaysia Derivatives Clearing Bhd (BMDCB) is the
sole clearinghouse for both financial and commodity derivatives. Prior to
Bursa Malaysia’s demutualization, BMDCB used to be known as Malaysia’s
Derivatives Clearinghouse (MDCH). Originally established in 1995 to handle
financial and commodity derivatives.

5.0 DERIVATIVES REGULATION IN MALAYSIA

The objective of regulation is always to ensure fair and transparent market

by enforcing ethical behavior on the part of all players. Until the early 1990s,
when the only derivatives traded were commodity derivatives, the industry
came under the purview of the Commodities Trading act, 1980/85. The
industry watchdog was the Commodities Trading Commission (CTC), the

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regulatory arm of the Ministry of Primary Industries. When the need for
financials derivatives became evident in the early 1990s, it was obvious that
new legislation and the new regulatory structure was needed.
The response came in 1993 with two major developments. The first
was the enactment of a new act, The Futures Industry Act (FIA), 1993. The
second was theh establishment of the Securities Commission under the
Securities Commission Act (SCA), 1993. The FIA 1993 and its amendments
form the regulatory framework for the trading of financial derivatives in
Malaysia. Though jurisdiction of the FIA is with the Ministry of Finance, all
enforcement and monitoring tasks are placed with the Securities
Commission. It is, therefore the Securities Commision that regulates and
ensures overall compliance of the FIA.
Under this regulatory structure, an exchange, is deemed a ‘self-
regulatory organization’ (SRO). This means that the Exchanges are
responsible for their operational compliance with the FIA. Aside from ensuring
self compliance, an exchange is also responsible as SRO for the compliance of
their members with the FIA. These the exchange does by means of the
various internal committees.
Until the later half of the 1990s, Malaysias derivatives industry had two
components, commodities and financial derivatives and two sets of
regulations. The Commodities Trading Act, (CTA), 1980/85 to govern
commodities and the Futures Industry Act, FIA, 1993 for financial derivatives.
Futhermore, there were also two regulators, the Commodities Trading
Commission and the Securities Commission. Each of these regulators came
under different ministries. The inherent duplications and the need for
streamlining became obvious. In April 1997, the regulatory framework
underwent the major restructuring. First, the Commodities Trading Act 1985
was repealed after the Futures Industries Act, 1993 was amended to include
the key requirements of the former. Next, the Commodities Trading
Commission was absorbed to be within the Securities Commission.

6.0 CONCLUSION

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Through this study, it was examined the trading of derivatives in Malaysia.
The different between Over-the-Counter markets and exchange trading was
discussed. While over-the-counter (OTC) markets are informal markets that
negotiable arrangements and customized contracts, exchange trade
standardized contracts. The two types of treding methods were also
discussed. The open-outcry of auction method involves competitive bidding
by traders on a designated trading floor. Trading is carried out by the use of
hand signals and shouting out orders. A screen based system on the other
hand works by means of a distributed computer system. Bids and offer are
keyed directly into terminals. The computer plays matchmaker to the buy and
sell orders. The advantages and disadvantages of each system were outlined.

This study also mentioned about the establishment and development

of BMDB and Malaysia’s earlier derivatives exchanges, COMMEX and KLOFFE.
BMDB trades the nine derivativecontract currently available in Malaysia.
Malaysia’s only derivatives clearing house in the Bursa Malaysia Derivatives
Clearing Bhd. Derivatives trading in Malaysia falls under the regulatory
framework of the Futures Industry Act (1993). While the Ministry of Finance is
responsible for overall implementation, regulation and enforcement of the FIA
(1993) is the responsibility of the Securities Commission.

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