Introducing NCEL Karachi Thursday, September 9, 2004

1. Introducing NCEL Karachi Thursday, September 9, 2004

2. Background • NCEL established on April 20, 2002 • Permission granted by SECP on May 16, 2002 • Present Shareholders: • KSE-40% • LSE-10% • ISE-10% • Pak Kuwait Investment Co. – 10% • Zarai Taraqiati Bank Ltd. – 10% • Another FI has an approval for a 10% equity stake

3. Highlights • First de-mutualized exchange in Pakistan • Firstfully integrated electronic exchange capable of also handling financial futures • First to employ modern risk management techniques – Value-at-Risk • Firstto introduce the concept of “The Central Counterparty” • First to introduce Vault Receipts and Warehouse Receipts • First to become a “Digital Certification Authority” in Pakistan – secure network access • First to deploy “Live Communications Sever”

4. FROM Limited access Price distortions Wide spreads or one way quotes Absence of standardization Counterparty risk Impediments in financing Lack of long term funding or there is a mismatch TO Equal access to all Observable future prices Narrow spreads and two way quotes Quality certification & standardization Central Counterparty Ease in financing Vibrant long term market Mission/Vision “To provide an opportunity to the farmers to farm for the market”

5. Benefits of a Derivatives Exchange • Helps in price discovery of both cash and futures • Helps in transferring risk – averse to risk to someone with an appetite • Helps in transforming cash markets into vibrant markets • Helps in transitioning investors into a more controlled environment • Helps in entrepreneurial activity in an economy • Helps in creating savings and investments in the long run • Helps in developing intellectual capital and awareness - enhances markets image and standing, and leads to an increase in FDI

6. 360° Company Update • Hardware and software fully installed • Members and their clients – Mock Trading • Gold will be the first contract to be listed • Regulations are ready and are to be approved by the Board and then SECP • Clearing Bank has been appointed for online bank transfers (MCB) • Cotton Yarn, Rice and Wheat contracts are being developed for Q4

7. 360° Company UpdateCont’d…. • 181 Members have been trained so far • Staff is highly educated and experienced in trading futures, risk management, IT, investment banking, agriculture, textiles, financial mathematics, operations, corporate & securities law, stock-broking, accounting, tax, process improvement, etc…… • “Go Live” ?

8. Key Drivers of Success • Provide a transparent platform for easy and equalaccess to all participants • Regulations will provide complete confidence and protectionto investors and users • Risk Management, and Surveillance & Monitoring will be based on the international “Best Practices” • Developing thoroughly researched contract specifications

9. Regulations • Conflict of interest clearly defined • Un-businesslike conduct, misconduct and un-professional conduct have been introduced • Board does not have the right to waive compliance • Incorporated Corporate Code of Governance and “Best Business Practices” • Committees only have recommendatory powers

10. Risk Management • Pre-trade risk checks • Clearing Deposits & Clearing Limits • Position Limits – Members & Clients • Variation margin – T+0 settlement in cash • Value-at-Risk methodology using Extreme Value Theory • Provision for intra-day margin calls • Exchange reserves the right to enforce special margins • A quantum leap ahead of the OTC market

11. Advantages of VaR • It captures an important aspect of risk in a single number • It is easy to understand • It asks the simple question: “How bad can things get?” • VaR models will be continuously back-tested and stress-tested

12. Margining - Example • Example – Gold • VaR for Clearing Limit = 2 * Sigma = 3% • Clearing Deposit: Rs1.0 million = x 33.33 • VaR for Initial Margin = 4 * Sigma = 5% • Initial Margin: Rs0.5 million = x 20.00 • Initial Margin: 99% VaR over 1 day • Spot/Delivery Month Margin: 99% VaR over 3 days

13. Pre-Trade Risk Management • Against an initial margin • Can also set: • Maximum click trading limit • Maximum order size • Maximum sum of contract size limits • Maximum long positions • Maximum short positions • Maximum intra-day loss

14. Pre-Trade Check Electronic Broker Member J-Trader Bank Buy/Sell Order SARA If P or C (SODNLV) < Order Margin Required Patsystems Back Office SODNLV No Updates Collateral Mgmt System Yes Matching Engine

15. BANK Accounts LEDGER MCB BANK Initial & Variation Margins Daily Sweeping of accounts Daily Account Swipes

16. NCEL is Central Counterparty • Upon matching of a trade, NCEL becomes a buyer to every seller and a seller to every buyer and guarantees settlement • The risk of each counterparty is transferred to a Central Counterparty (CCP) • CCP is fundamental to the existence of a derivatives market • NCEL has made an initial contribution of Rs100 million to its Settlement Guarantee Fund

17. Bilateral versus CCP (Multilateral) Seller Buyer CCP Seller Buyer

18. Central Counterparty • Benefits of CCP: • Acts as a Central Bank to Clearing Members • Simplifies Risk Management • Creates Process Efficiency • Increases Liquidity • Anonymity • Standardization of Processing • Clearing Members are jointly and severally liable to ensure replenishment of the SGF, in case of a major payout

19. Online Market Surveillance • Clearing Limits • Position Limits • Crossing Trades (Member/Client) – 5 seconds standing in the market • Wash Trading • Front Running • Trading Opposites – pre-arranged trading

20. Trading @ NCEL • Single Electronic front end trading platform accessible up to the client level • Using a single front end for trading on Multiple Markets • Centralized Clearing & Settlement Infrastructure • Multilateral Netting • Cross Margining if we run multiple markets

21. Trading @ NCEL Cont’d… • Front End Trading Platform should provide: • Can be used for accessing multiple markets (J Trader being used by over 6,000 traders for accessing 13 Electronic Exchanges with 500,000 futures contracts being traded every single day) • H Trader (hand held device such as a Palm Pilot) • Efficient screen based trading • Complete anonymity • Order driven with price/time priority

22. Trading on Multiple Markets

23. Technology • Features & Functionalities: • Pre-Trade Check based on an initial margin for all • Setting trading limits based on an initial margin • Monitoring of Clearing Limits in real time • Monitoring of Position Limits (Members and Clients) in real time • Bank transfers • Capability of handling shares as collateral • Back Office ledgers - accounting • Share release and bank transfer instructions

24. Agriculture Sector • Platform for price discovery and hedging of price risk for farmers • Provide a mechanism to lenders for moving into collateralized commodity financing • Introduce quality standardization • Impetus for investment in infrastructure • However, the pre-requisite would be an efficient and a well developed out reach awareness program

25. Wheat Price Comparison between Major & Minor Markets of Pakistan(For Three Years) Sowing Sowing Harvesting Sowing Harvesting Harvesting Red = Average of Three Major Markets Yellow = Average of 9 minor Markets 2000-01 2001-02 2002-03 Source: Federal Bureau of Statistics

26. Commodity Based Financing • Structured form of financing with an objective of transferring risk from an entity to a commodity • In discussion with an NGO to undertake financing as a pilot project on the following basis : 1. Pre-sowing for inputs against NCEL contract (short) and social collateral 2. Post-harvest and upon storage against a warehouse receipt

27. Other NCEL Initiatives

28. Analytics @ NCEL • Risk Management • Should not be viewed as static • Time value of money • Being a CCP would require huge amount of risk absorption • Using VaR to quantify and manage this risk • Initial Margin and Clearing Deposits to be determined using VaR • New Product Development • Benchmark Yield Curve • Interest Rate Risk • Interest Rate Futures • Stock Index Futures

29. What is wrong with YTM • A bond’s computed YTM will only actually be earned if cash flows are immediately reinvested • One cannot use YTMs of existing bonds to price a new issue • YTM is not a pricing kernel • YTM believes the yield curve is flat; it is not a path to thinking and understanding a non-flat yield curve • It plays no role in the economics of fixed income markets

30. Zero Coupon Yield Curve • Provides a benchmark for valuing GOP securities across all maturities irrespective of liquidity • To study impact of monetary policy • Will help in asset and liability management of institutions with substantial investment in GOP securities • Has multiple uses including deriving forward currency rates • Will take Pakistan a step closer to international markets

31. Deriving ZCYC Three main issues: 1. Given a series of GOP securities, how do you construct the yield curve? a. Linear Extrapolation b. Bootstrapping c. Cubic Splines 2. What GOP securities data should be used to construct it? a. Primary auction data – last 6 months b. Secondary market data – individual instruments • What technique? a. Nelson Siegel b. Extended Nelson Siegel

32. ZCYC for Pakistan

33. Net Interest Margin *Source: THK Banking Survey 2003 Observations: 1. All markets, other than Pakistan, have efficient screen based exchange traded interest rate hedging products 2. All markets, other than Pakistan, have benchmark yield curves

34. Net Interest Margin Source: Malaysian Institute of Economic Research Publication

35. Present Money Market • Market trades on the YTM curve • OTC – impedes price discovery • Fragmented information - an impediment to liquidity • Credit risk • Extreme concentration • Lack of Hedging Opportunities

36. Developing Interest Rate Futures Contract Specifications • A 8.0% 2014 PIB new issue (example) will be quite liquid • Could it be used as underlying for a interest rate futures contract? • Problems: • Short squeeze • It would no longer be ’quite liquid’ in the future • It does not directly link up to hedging needs

37. Our Approach • Cash settlement to notional zero coupon bond • Interest rate futures based on the notional T-Bills & PIBs • Trading such a contract will not require spot market infrastructure - billions being transferred on a daily basis • Eliminates “Cheapest to Deliver” games

38. Interest Rate Futures Contract • Notional 90 day & I Year T-Bills, Notional 5 Year PIB with Coupon, Notional 10 Year Zero Coupon Bond, etc. • Duration of Contracts – varied • Listing Frequency - initially, one every month • Cash settlement • Lot size, tick size, price steps, order size, etc. to be determined together with market participants • Base price to be determined using theoretical futures price - ZCYC

39. Thank You