How will the new derivative products announced by the Securities and Exchange Board of India (Sebi) impact the equity markets?
Equity derivatives turnover on the National Stock Exchange (NSE) already is four times that of its cash market turnover. Sebi’s move to introduce new products will only enhance the shift in liquidity to the derivatives market. But that’s not a bad thing, since there would be a related increase in cash market turnover as well, because of arbitrage trades and because of the overall increase in participation.
In addition, considering that a new product was launched six years ago, it was high time Indian market participants had access to more options.
A basic objective, according to Sebi, is to arrest the export of India’s financial markets. For instance, large brokers in offshore markets such as Hong Kong and Singapore offer structured products not available in the Indian markets, and also cater to clients who aren’t allowed to participate in India. Another instance is a Dubai exchange launching rupee-dollar futures. While the first reaction by regulators such as Sebi and the Reserve Bank of India (RBI) came in the form of curbs on participation in such markets on entities regulated by them, they are now looking at launching such products in the domestic markets.
Needless to say, Indian market participants are thrilled at the prospect of having a wider range of products to choose from. The availability of long-dated options is even expected to bring in a new set of players into the derivatives market. A number of institutional investors would prefer long-dated contracts since they avoid the hassle and cost of rolling over one-/two-/three-month contracts. Sebi has also talked of derivatives on a volatility index, but these are likely to be attractive only for institutional investors and a few sophisticated option traders. After all, Indian retail participants haven’t even taken up to vanilla options trading in a big way. Similarly, exchange-traded products to cater to different investment strategies and over-the-counter derivatives would primarily benefit institutional players. But even their increased participation will deepen the overall market, since they currently account for just around 12% of turnover.
On the other end of the spectrum, Sebi has approved mini-contracts on equity indices, similar to the E-mini series offered at the Chicago Mercantile Exchange (CME). This is intended to increase retail participation. For instance, the CME’s S&P 500 futures contracts are worth $3,67,500 (about Rs1.4 crore) and were way out of the reach of retail investors. The E-mini series on the S&P 500 is worth just one fifth of that ($73,500) and is much more accessible. In the Indian derivatives market, the size of the Nifty futures contract is already a low Rs3 lakh, with the initial margin being just 15-20% of that amount. As a result, retail investors already participate in a big way and so the incremental benefit should be limited.
Perhaps the biggest change will be brought in by debt market and currency derivatives. Abroad, the largest derivative products are in these markets. If these products are indeed launched under Sebi regulation, it would perhaps be the first major recommendation of the committee on making Mumbai an international financial centre to be implemented. The committee’s report had pointed out that the responsibility for regulating “spot and derivative instruments on interest rates, currencies and credit risk…needs to be moved to the Sebi without further ado.”
However, the experience with Sebi’s plans to allow institutional investors to short- sell equities and simultaneously launch a securities lending and borrowing platform suggests that the launch of interest rate and currency derivatives will be fraught with similar hurdles. Although the finance ministry and Sebi have approved short-selling and stock lending and borrowing, these facilities are still not available, presumably because of concerns at RBI. Besides, interest rate futures launched by NSE a few years ago failed primarily because of restrictions put on bank participation by RBI. Experts say Sebi’s plans for derivatives based on interest rates and currency will take off only if there is no restriction on participation and product design is not faulty.
RBI’s November bulletin has plenty of interesting data on the trends in commercial banking from 1991-92 to 2005-06. Data on interest rates show that the share of loans given under high interest rates started decreasing from 1999-2000 onwards. In 1998-99, for instance, 62.6% of the outstanding loans had to pay interest at 15% or higher rates. In 2005-06, the last year covered by the RBI study, loans paying an interest rate of 15% and more formed merely 14.67% of all outstanding loans. Loans with a rate of interest of less than 12% formed 44.46% of all outstanding loans, compared with 9.24% at the turn of the century.
It’s very clear that lower interest rates have been responsible to a large extent for the boom of the last few years, not only by stoking consumption, but also by increasing corporate earnings.
But were the lower interest rates also responsible for the stock market boom? The fall in interest rates in the US and the UK in the 1990s, for example, has been cited as the main reason for the bull run in their stock markets in the late 1980s and 1990s. Prime lending rates in the US fell from 20% in 1981 to 7.5% by 1986 and to 6.25% by March 1994. The Dow Jones Industrial Average went up from around 1,000 in 1982 to around 3,000 in 1991 and to 10,000 by 1999. In the UK, the base lending rate, which was 15% in December 1989, fell to 5.5% by December 1993. The Financial Times Stock Exchange (FTSE) 100 moved up from around 1,000 in May 1984 to 2,500 by May 1991 and to 4,000 by November 1996. But, unlike the US and the UK markets, the Indian market is dependent on foreign capital. It could be argued that it is the lower interest rates in the US markets that have led to the bull run in Indian equities. Many Indian companies are no longer dependent on domestic interest rates, since they raise funds abroad. For larger companies, the impact of interest rates is now mainly on revenues, through the effect of interest rates on domestic consumption.
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