India’s single stock futures market often faces this criticism: It’s a punter’s den. This is not surprising: Stock futures offer equity traders unparalleled leverage, allowing them to take a position that could be as high as five times the cash market equivalent, with the same amount of capital. As a result, it’s become a good proxy for the level of speculation in the markets—higher the turnover relative to the cash segment, higher the speculation in the markets.
Remember, stock futures were nowhere in the scheme of things when the Securities and Exchange Board of India (Sebi)-appointed L.C. Gupta committee put out its recommendations on developing derivatives markets in India. The committee had said that hedging is the key aspect of derivatives and also its basic economic purpose, citing the US futures regulator Commodity Futures Trading Commission’s policy of examining the ability of a product to provide hedging while considering proposals for approval of a new derivative product.
Single stock futures perform no hedging function. With stock options, one can at least buy insurance against an adverse movement for a limited period. By paying a relatively small sum (option premium), an investor can protect himself from large losses in the cash market position. But selling stock futures against a long position in the cash market is tantamount to liquidating the cash market position, since the profit on the futures position will be completely offset by losses on the cash market position and vice-versa.
What, then, could be the economic purpose of the single stock futures? Put simply, they support leveraged positions, which, in turn, improves liquidity in the markets, and, hence, price discovery. The recent market correction has taken the wind out of leveraged speculators, but just prior to the crash, on 10 January, turnover of the near-month futures contracts was 2.7 times higher than cash market turnover for the same stocks. The higher the liquidity, the lower the cost of executing trades, especially for institutional investors, whose large orders can otherwise severely impact prices. As one fund manager puts it crudely: “Stock futures help manage liquidity risk.”
Ajay Shah, senior fellow at the National Institute of Public Finance and Policy, says, “Thanks to leverage, traders with knowledge and information can have a greater say in price discovery, which is otherwise the domain of those with large capital in the form of money and/or shares.” For instance, someone who’s convinced power stocks will correct sharply can take a short position that’s five times the value of his capital with stock futures.
Needless to say, leverage will also attract the wrong kinds, and that too in greater measure. But note that leverage is not the preserve of the stock futures market. It’s available, albeit to a lesser degree, with loans against securities, margin funding and the like even in the cash segment. Of course, traders need to be a lot more careful with stock futures. And there also needs to be a curb on the number of stocks on which futures are permitted, as they are meant only for very liquid stocks. Given the nature of the product, it’s bound to have a fair share of criticism—it’s just a substitute for the old badla system; it has not taken off in developed markets; it adds to volatility. While there may be some truth in all these arguments, there’s little doubt that stock futures have led to a stark improvement in liquidity in the Indian markets. According to Shah, “Policymakers did well to launch stock futures about a year-and-a-half after index futures were launched, ensuring that liquidity takes root in the conceptually more complex index products first”. Currently, Nifty products are the most liquid in both the futures and options segments, which perhaps wouldn’t be the case if stock futures had come as a quick replacement forbadla.
Revisiting the derivatives risk management system
According to a report in The Economic Times, Sebi is considering measures such as circuit filters and physical settlement for derivatives based on single stocks. The new leadership at Sebi would do well to nip such proposals in the bud. While a marketwide circuit filter can be a good remedial measure especially when there is a sudden dearth of liquidity, extending it to single stocks doesn’t make sense.
Circuit filters would put an unhealthy restraint on prices from reflecting true changes in fundamentals. If the issue is an acute shortage of liquidity and hence a sharp drop in prices, this will result in the marketwide circuit breaker being triggered. As far as physical settlement in stock derivatives goes, this would take away the very purpose of leverage, since traders have to be prepared with cash/stocks to facilitate delivery at the time of expiry.
While buffer margins, with exchanges or brokers, should alleviate the problem of frequent margin calls and the resultant panic selling, there still is the problem of sharp price movements in the early part of a day’s trading session. The market-wide circuit filter was hit within minutes of trading on 22 January, mainly because of the dearth of liquidity early in the day’s trade. One way of solving this would be to conduct a call auction to determine the opening price.
A call auction is a process where limit orders are collected for a fixed period, and the price that enables the largest number of orders to be executed is chosen. The current system works superbly when there’s a healthy order flow into the system. But in abnormal cases, when major selling is expected, buy orders would be hard to come by in the early part of the trade. A call auction is a good way to establish a consensus opening price for securities.
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