The National Stock Exchange’s (NSE) recent decision to include an additional 39 stocks for futures and options trading has caught flak from some brokers, who say that allowing derivatives on so-called “less liquid” stocks could lead to manipulation. The new list includes stocks such as MRF Ltd and Container Corp. of India Ltd, which are rather illiquid in the cash segment of the bourse.
But it must be noted that manipulating stocks using futures and options isn’t a given just because the underlying stock is illiquid. There is a regulation to rein in manipulators that limits marketwide futures and options positions at 20% of the available free-float of a stock. There are also memberwide limits, which are much smaller.
If the argument is that members can collude and together corner all the stock permissible under futures and options, perhaps the criticism should be focused on the exchange’s and regulator’s surveillance abilities. Keeping out less liquid stocks from the derivatives segment may not be the answer. In any case, there have so far been hardly any reported instances of manipulation using the derivatives market.
J.R. Varma of the Indian Institute of Management at Ahmedabad says, “If liquidity is used as a condition for introducing derivatives, we’ll end up in a vicious cycle where stocks that are already liquid will become more liquid thanks to the introduction of derivatives, and the less liquid, ones will remain illiquid. This dichotomy will get worse.”
Thanks to the the leverage they provide, single-stock derivatives attract larger volumes and generally enhance the liquidity and price discovery in the market. True, there are some stocks on which derivatives have been introduced, which still hardly trade. That, however, is no reason to not introduce futures and options on less liquid stocks. Even if liquidity doesn’t improve in some cases, the fact that it does in some others means that it is a net positive for the market.
Clearly, less liquid stocks are likely to be more volatile and, coupled with the leverage of derivatives contracts, they can cause huge losses to market participants. But traders involved in the derivatives segment need to be aware of the risks involved. It’s unfair to blame the market after taking uncalled-for risks. The exchange, on its part, needs to make sure its members pay adequate margins and collateral to negate settlement risks.
Another criticism NSE faces when it introduces new stocks for futures and options trading is that it’s just a ploy to capture market share from rival Bombay Stock Exchange (BSE). While it’s true that NSE gains share even in cash market trades for stocks on which futures and options are available, the blame, if any, lies at BSE’s end for not creating a robust derivatives trading platform. In an environment where derivatives are increasingly important, it’s inevitable that NSE will continue to gain share.
SGX competition no worry?
Securities and Exchange Board of India (Sebi) chairman C.B. Bhave has an interesting response to the loss in India’s market share in index futures trading to Singapore. He says the rise in volumes in Singapore Exchange (SGX) isn’t a cause for concern as long as India’s volumes are intact. It’s only when Nifty futures volumes on NSE start dropping that one should be concerned about the threat fromSingapore.
NSE had a share of about 99% in the Nifty futures market prior to Sebi’s ban on participatory notes (PNs) last October. This has now fallen to 89%. Assuming constant prices and exchange rates, total Nifty futures turnover across both exchanges has risen by about 28% between last October and this July. NSE’s turnover, however, has risen by a much lower 14.5%.
If NSE’s shares were traded on a stock exchange, its investors wouldn’t have taken kindly to this underperformance. Take the case of Hindustan Unilever Ltd (HUL), which has grown annual revenues at an average rate of about 4% in the past nine years, at a time when overall sales of consumer goods has risen at a much faster pace. While shares of other consumer goods companies more than doubled during that period—some rising by as much as eight times—HUL’s shares have risen by less than 30%.
Currently, SGX’s volumes aren’t high enough to threaten NSE’s domination of the Nifty futures market. Some observers feel that since NSE is still the primary “price-giver” to the market, there’s no cause for concern, partly echoing the Sebi chairman’s view.
But what’s disconcerting is that the rise in SGX’s volumes came about soon after the restrictions on PNs. This is almost akin to handing over market share on a platter. SGX, of course, did its bit by cutting the contract size on Nifty futures by one-fifth soon after the restrictions.
While competition for any product is good, it’s unfair when there are restraints on foreign investors on one platform, and no restrictions on the other. The reason NSE’s volumes continue to be high despite this is the fact that domestic participation is robust. But that’s hardly any reason for complacency.
It must be noted, however, that the central bank has for years opposed PNs and has been calling for restrictions on their use. The restrictions announced by Sebi last October were also seen as a move to curb capital inflows, the domain of the Reserve Bank of India. Market observers feel that progress on the issue is not straightforward, since the central bank also needs to be on board.
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