Will SGX’s Nifty options contract benefit from regulatory arbitrage?

Will SGX’s Nifty options contract benefit from regulatory arbitrage?

The Singapore Exchange (SGX) has said that it is consulting the public on its proposed introduction of options contracts on the Nifty index. The exchange has had a fair amount of success with its Nifty futures contract, which at one point had garnered an open interest position as high as its counterpart on India’s National Stock Exchange.

That was primarily on account of regulatory arbitrage. Volumes and open interest rose on the SGX soon after the Securities and Exchange Board of India (Sebi) banned the use of participatory notes in October 2007. Market participants who couldn’t access Indian exchanges due to the restrictions chose to do so on SGX. Within months of the ban, SGX’s share in terms of open interest rose from around 5% to 50%. Sebi lifted the ban within a year and SGX lost some of its advantage. Even so, it continues to enjoy a share of 25-30% in the total open interest on Nifty futures.

The Nifty options contract may benefit from some form of regulatory arbitrage as well since Singapore doesn’t levy a transaction tax akin to India’s securities transaction tax (STT). This difference wouldn’t affect option writers much because they pay STT at the rate of only 0.017%, and that too only on the option premium. Option buyers don’t have to pay STT, unless the option is exercised. Yogesh Radke, head of quantitative research at Edelweiss Securities Ltd, explains, “The STT applicable when an option expires in the money is relatively high. Options that expire in the money are construed to be exercised and attract STT at the rate of 0.125% of the notional value of the contract. Instead, if an option buyer chooses to square off the position by selling the option, then the STT applicable is 0.017% of the total premium received. For this reason, options trade at relatively lower values compared with their intrinsic worth close to expiry."

Consider a Nifty option which has a strike price of 6,100 and expires in the money—with the Nifty trading at 6,150. If the option buyer chooses to let the contract expire, his STT outgo would be Rs384.40, assuming the trade is for a minimum lot size of 50 (0.125% of notional value; i.e. Rs6,150x50). On expiry day, this option would trade at around Rs60 (Rs3,000 for a contract with a lot size of 50.) If the trader chooses to square off the position by selling the contract, the applicable STT would only be Rs0.51 (0.017% of the option premium, Rs3,000).

For traders who work on thin margins, the additional tax outgo amounting to nearly 12.5 basis points is rather high to be ignored. (One basis point is one-hundredth of a percentage point.) For this reason, traders prefer to square off by selling their positions close to expiry. Of course, such traders who have access to the Singapore market would prefer to trade there instead to avoid an additional transaction. It remains to be seen how big this universe is. But needless to say, the relatively high rate of STT for options that are exercised is an irritant that should be done away with.

On a slightly different note, it’s interesting to see the manner in which SGX is going about introducing a new product on its exchange platform. It has put out its proposed contract specifications on its website for public comments for a period of two weeks.

This is quite different from the way new product introduction happens in India. Here, the job of designing new products is the preserve of the market regulator. Of course, it would argue that it also follows a consultative approach before announcing the final design of a product. But experience with products such as interest rate futures and securities lending and borrowing shows that the final product is far from what market participants are comfortable with.

Policymakers here could take a leaf out of the SGX’s books. Not only is it catering to the growing demand for products that give exposure to the Indian economy, but is also doing so in a consultative approach with market participants and the public at large. Of course, while this improves the chances of the product’s success, it doesn’t provide any guarantee. For that matter, even with Sebi’s model of a regulator-designed product, there are no guarantees of a product’s success.

It seems best that market intermediaries and participants are involved in the decision-making process on what products should trade in the market. This is not to say that the regulator should throw all caution to the wind—all this should happen within the broad risk management framework prescribed by the regulator.

To read all of Mobis Philipose’s earlier columns, go to www.livemint.com/inthemoney

Your comments are welcome at inthemoney@livemint.com