The final report of the derivatives market review committee appointed by the Securities and Exchange Board of India (Sebi) doesn’t have much to add to the preliminary note, called “New products in futures and options segment”, released last year. The earlier note suggested mini contracts, long-dated options, derivatives on a volatility index, options on futures, derivatives on a bond index, currency derivatives and exchange-traded products involving various strategies. The final report includes the following additional suggestions—exchange-traded credit derivatives; over-the-counter (OTC) products; and exchange-traded third-party products—apart from making slight modifications to the existing ones.
To have credit derivatives trade on an exchange platform is something the ministry of finance has been considering for sometime now. Talk of OTC derivatives, again, isn’t new. Sebi itself has been talking of it since the ban on participatory notes in October 2007. The only new suggestion seems to be exchange-traded third-party products, which are essentially covered calls or structured products issued by institutions holding large stock of a listed firm. As the committee report notes, these institutions may not be able to trade these shares owing to internal policy/directives, effectively reducing the free float in the market. If institutions are allowed to issue structured products with the shares as underlying and these instruments are traded on the exchange, it would not only enable them to generate additional income from their holdings, but also result in effectively increasing the liquidity of the underlying shares.
On OTC derivatives, the committee has laid rather stringent guidelines on who can participate, with a minimum networth restriction of Rs500 crore at the client-level. Needless to say, structured products are best left for entities who are able to not only understand the risks involved, but also weather large losses. But one requirement that OTC contracts are to be used for non-standard products could be done away with. One of the committee’s members, the deputy managing director of the National Stock Exchange, has suggested that OTC contracts should not be identical to the contracts traded on exchanges. It’s interesting to note here that the currency futures contract launched last year is identical in its pay-off to the OTC forward contract, which has existed for years. It seems odd to say that the reverse won’t be allowed. While it’s a healthy trend for more and more products to move to the exchange platform, given the benefits of transparency and centralized clearing, it’s unfair to put restrictions on the OTC market.
The OTC segment, in fact, can act as competition to exchanges and keep them on their toes. To restrain them in terms of product design will be effectively killing competition, which is undesirable. Not that exchanges have to worry much. Traders first worry about liquidity, which is available in plenty on exchanges rather than on the OTC platform. It’s unlikely that OTC products with a similar pay-off will be able to pull a large section of exchange users, since the transaction cost would be much higher.
Apart from new products, the committee has some other suggestions such as an increase in the marketwide position limit allowed for single-stock derivatives. The committee has recommended that the limit should be doubled to 40% of the available free-float. Given the high leverage the derivatives market provides, this seems like a risky proposition. The aim of keeping the limit low was to rule out the possibility of manipulation of share prices using the derivatives market. While memberwide and clientwide limits ensure that positions aren’t concentrated in the hands of a few, the marketwide position limit ensures that manipulation is difficult even if traders collude. The committee goes on to suggest that the limit should eventually be removed.
The committee has also tightened the selection norms for permitting derivatives in single stocks. It has raised the bar both in terms of minimum free-float market cap and liquidity. Similarly, the norms for sectoral indices that qualify for derivatives trading have been made more stringent. This seems to be needless interference. As long as necessary safeguards such as position limits are in place, it should be left to the exchanges to decide which stocks and indices they want to introduce new contracts on. In fact, experts point out that new product introduction is best left to market forces. The current manner in which the regulator approves products is akin to the licence raj, says an exchange official on condition of anonymity. Hopefully, with the anticipated increase in competition among stock exchanges, the policy approach to new product introduction in the derivatives market should also improve.
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