How can Sebi moderate India’s derivatives cholesterol?
The Securities and Exchange Board of India (Sebi) has released a discussion paper on Growth And Development Of Equity Derivative Market in India. The discussion paper is replete with data on the structure of India’s equity markets across stocks and derivatives. The paper concludes that the market is disproportionately skewed towards derivatives and invites suggestions for policy interventions to correct this abnormality. Sebi must be lauded for raising important policy issues in the public domain, backed by rigorous data and analysis. This piece analyses whether India’s equity markets are indeed speculative in nature and if yes, whether policy interventions are necessary, whether they work, and if they do, what some of the appropriate policy ideas could be.
Indian equity investors have an inexplicable fetish for complex derivative products. In FY2017, just 700,000 individuals bought and sold nearly $4 trillion notional worth of derivatives. This is twice as much as all foreign institutional investors in India combined. India’s stock exchanges trade eight times more equity derivatives than the Hong Kong (HK) stock exchange, even though the value of all companies listed in HK is double that of India. Indian retail investors also seem to prefer the riskier of the two categories of derivatives products between stock futures and options. The potential gain or loss in futures is unlimited, while it is limited in options. Retail investors in India bet on a notional value of $800 billion of stock futures in 2016, more than the value of stock futures traded in all of Europe, Hong Kong and Singapore combined. Retail investors account for half of all the stock futures trading in India, while sophisticated institutional investors account for just one-tenth and prefer stock options instead. Not only do Indian retail investors have a puzzling fascination for high-risk derivative products, they seem addicted to the riskiest category. Why do these retail investors indulge in such excessive derivatives trading?
In theory, derivatives are a product designed for hedging risk. If an investor owns shares of Infosys and wants to minimize risk, he can hedge his risk by buying or selling Infosys futures or options. Alternatively, one can buy or sell Infosys futures or options without owning any shares, just to punt on its price movement, speculators as they are called. Any equity derivatives market is a delicate balance between these hedgers and speculators. Are Indian retail investors in derivatives speculators or hedgers?
Two-thirds of non-promoter shares in listed Indian companies are owned by foreign and domestic institutions, while retail investors own a mere one-sixth. Yet institutional investors account for a mere one-tenth of all derivatives trading in India while retail and proprietary traders, who don’t own as many shares as institutions, account for 90%. So it can be imputed that the bulk of the derivatives trading by retail investors is not to hedge their stock positions (which are minimal) but to speculate on price movements. India’s equity markets are dominated by small investors speculating heavily through trading in high risk derivatives. The logical follow-up question is—so what? Some may argue that it is the individuals’ choice to risk their money. True, but it is equally important to ask what the negative externalities of such excessive derivatives trading are. In other words, is there a looming systemic risk or potential dangers to others arising out of the highly speculative nature of the Indian equity markets?
It is not our contention that retail investors will lose $4 trillion if the markets turn sour. But the financial risks are tangible and unpredictable. Given the 2008 ‘Black Swan’ event experience, it is clear another similar event can lead to catastrophic consequences for these investors and cascade down to the larger market. That derivatives can cause extreme losses that one cannot quantify or foresee is an indisputable truth. It is, then, only appropriate that steps be taken to amend this skew rather than wait for it to implode and clean up the mess later.
Beyond the financial risk, there are other intangible effects of high derivatives trading. Speculative investors in a market only attract other speculators. The sheer dominance of such speculative investors in India’s equity markets has lent it the character of a “speculative den”, which is corroborated by Sebi’s household investor surveys. Households’ trust in equity markets is abysmally low, according to the survey. The number of retail investors, either directly in the markets or indirectly through mutual funds, has remained roughly flat for a decade. Indian households have largely shunned participation in equity markets out of fear of the “casino”. Companies are able to raise only as much capital on India’s stock exchanges as they did a decade ago. Mutual funds have only doubled the amount of capital raised from Indian households over an entire decade. But derivatives trading has gone up 30 times. So derivatives have not helped achieve the goal of making markets more efficient and enabling companies to raise more capital. If anything, it is hurting this very objective.
Do policy measures have an impact on the trading behaviour of derivatives? The introduction of the securities transaction tax (STT) in 2005 created an arbitrage between stocks and derivatives, with a lower STT for derivatives vis-à-vis stocks. The immediate impact was a big shift towards trading in derivatives which has continued to this day (see chart 1).
A similar shift can be observed when STT was reduced for options vis-à-vis futures in FY2009. Triggered by this, institutional investors that had previously traded in index futures shifted to trading in index options. In 2008, index options volumes were just one-third of index futures. Since the STT change in 2009, index options grew to 12 times that of index futures (see chart 2).
Another example is when Sebi increased the minimum contract size for derivatives contracts from Rs2 lakh to Rs5 lakh in FY2016. It had an immediate impact and derivatives trading fell nearly 10%, the first time in nearly a decade. It is thus clear that policy interventions can have a substantial impact in correcting the current skew in India’s equity derivatives markets. What should these policy interventions be?
Increase in contract size
When derivatives were introduced in 2000, the minimum contract size was set at Rs2 lakh. Since then, the average Indian’s income has increased five times, the total value of all companies on the stock exchanges has risen 20 times and the BSE Sensex has gone up 10 times. But the minimum contract size for derivatives was increased to only Rs5 lakh, just two years ago. The minimum contract size can further be doubled to Rs10 lakh, which will be in line with the increases in other market parameters. This will ensure that the bar for small investors indulging in excessive risk-taking in derivatives is raised significantly.
Substantially increase margin requirements on options
According to the Sebi paper, most retail investors indulge in selling derivatives (options) to collect the upfront cash they can garner. For most individual investors, the idea of receiving cash for initiating a trade is exciting but it is fraught with big risks. Investor education and other clichéd solutions aside, the best way to stop investors from harming themselves is to increase the cost of pursuing such strategies. For writing options, it would be more prudent to prescribe a margin of 25% of the notional value or the currently existing formula, whichever is greater.
Transaction tax rationalization
Taxation is not under the purview of Sebi, so this may be an inappropriate policy recommendation for it. Nevertheless, transaction tax arbitrage between stocks and derivatives is the fountain-head for India’s distorted market structure today. Hence, it is important to address this and ensure there is parity in transaction taxes between stocks and derivatives by increasing transaction taxes on derivatives.
Accredited investor regime
With the advent of Aadhaar and other databases, it is now possible to determine the risk profile of an investor much more easily. It is then important to usher in an accredited investor framework to determine product eligibility for an investor based on their income levels and risk profile. A proper accredited investor regime based on one’s income-tax returns and Aadhaar will create a more robust eligibility framework for investing in risky products.
Financial Products Authority
Eric Posner, law professor at the University of Chicago and an ardent free market proponent, made a case for a Financial Products Authority (FPA), similar to the food and drug administration (FDA), which has the responsibility of certifying products for consumption. Given the considerable damage that unsuitable financial products can cause to household finances, the idea of an FPA along the lines of an FDA is sensible. The FPA can be a body set up jointly by Sebi and the financial services industry to issue guidelines and eligibility criteria for high-risk financial products such as derivatives. This will also mean that Sebi will not be the sole judge of financial innovation but an empowered body with industry participants.
Ever since the Dutch East India Company issued shares to the general public in 1602 to raise capital to build the spice trade, marking the beginning of the stock market, the primary goal of a stock market in a nation’s economy has been to mobilize household savings to raise capital for companies which then create jobs and boost economic growth. Trading in shares and hedging through derivatives are all secondary and tertiary objectives to help the primary goal. Derivatives—when used overwhelmingly for speculative purposes—are economically unproductive. To be clear, we are not calling for a ban on derivatives. Derivatives are like cholesterol in the human body—useful in moderate amounts, dangerous in excess. It is important to not miss this big picture in our ideological enthusiasm for free and unfettered financial markets.
Praveen Chakravarty and V. Anantha Nageswaran are, respectively, senior fellow, IDFC Institute, and senior adjunct fellow, Gateway House.