Last week, this paper carried two starkly different views on the role of retail investors. One view, based on a study of the investment behaviour of about 12 million retail investor accounts in the Indian stock market, was that they appear to learn better investment habits over time and should be left alone by policymakers. The other article said the collective behaviour of retail investors in the equity derivatives markets has been overly speculative and policymakers should intervene to bring about a balance.
This column has argued for policy intervention to improve the quality of the equity markets (bit.ly/1DafnJK and bit.ly/1qWk2su). Of course, the policy interventions mentioned in these articles are nothing like those proposed by the three finance and economics practitioners, Praveen Chakravarty, V. Anantha Nageswaran and Ajit Ranade, who co-authored the second-mentioned view.
Their article suggests that the minimum contract size for equity derivatives should be increased to restore balance between speculation and investing. To start with, defining what is speculation and what is investing is tricky. An India-based professor of finance says that there’s an old joke which goes, “I’m an investor; you’re a speculator.” The same goes with the distinction between hedging and speculation. A fund manager who chooses not to hedge his portfolio is speculating that prices won’t fall. And one who does choose to hedge is taking a bet that there is a likelihood of price correction. Who’s hedging and who’s speculating? Go figure.
For that matter, an investor may choose to take a long position in the futures or options market, because it is more liquid than the cash market; but may be adequately capitalized to offset the position by taking delivery in the cash market. Such trading activity, which started with a naked long position in the derivatives market, could be termed as both speculative as well as investment depending on the definition one uses.
Tarun Ramadorai, professor of financial economics at Said Business School, University of Oxford, who articulated the first view about no policy restrictions on retail investors, wrote in his article, “Unfortunately, there is not a significant amount of publicly available data or analysis which details the behaviour of investors in Indian equity derivatives markets, so opinions are being formed by analysis that uses broad information about equity derivatives trading volume. But such aggregate information makes it virtually impossible to arrive at definitive conclusions.”
For instance, one of the arguments by Chakravarty and his co-authors is that retail investors account for only 18% of the total equity stock issued in the country; but along with proprietary traders, account for 83% of equity derivatives volumes. First, it makes no sense to club prop trades with individual accounts. A large part of prop trades are purely done for arbitrage between different markets. To infer that trades by these two categories are largely speculative is incorrect. Another problem with the data is that exchanges categorize trades by high net worth individuals (HNIs) as retail trades. It’s nobody’s case that HNIs should be protected by regulators from betting on derivatives and losing money.
And even with smaller retail traders who can take derivatives positions, it must be noted that the prevalent margining system allows positions only to the extent of capitalization. Even though leverage is allowed, margins are calculated using stringent value at risk measures, which means that investors have already deposited with brokers and exchanges amounts that they could potentially lose from their positions. In the case of unexpected losses, if they can’t bring in additional margins, their positions will be closed out, causing no risk to the system at large.
The authors intermittently quote a report by the L.C. Gupta committee to support the argument that there should be a healthy balance between speculative and hedging activity. What they fail to note, however, is that the committee welcomed the presence of “well-capitalized speculators”, a criteria which the current risk management system helps meet.
What about the argument that India should follow the path of Korean policymakers, who have discouraged retail participation by increasing the contract size? In Korea’s case, the evidence showed that retail investors using online trading systems were being picked off by sophisticated investors, and that the trading culture had permeated to an extent where it had become a societal problem. There is no evidence, even anecdotal, that a large number of Indians are losing money heavily because of equity derivatives trading.
The authors also suggest that institutional activity in the derivatives segment is more desirable, based on an assumption that all of it is hedging activity. But according to a former equity derivatives dealer at a multi-national bank, a sizeable portion of foreign institutional investor activity is either arbitrage or speculation.
What the authors have glaringly missed is that domestic institutional participation is almost nil, and this is because of lapses by policymakers. Again, the Gupta committee report had recommended that prohibitions on hedging by institutions must be removed. But the experience on this front hasn’t been good. The Securities and Exchange Board of India has clamped down on use of derivatives by mutual funds (MFs) since 2010, after allowing them relative freedom earlier; there are restrictions on insurers and banks. The proportion of hedging activity will increase when such market participants use the markets; not by forcing speculators out.
As far as the cash market goes, it has been said in a number of forums that the government must allow and encourage equity investments by pension funds. This would be an appropriate policy response to the problem, by encouraging MFs and pension funds, rather than expect novices to enter the equity market directly.
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