Is equity derivativesʼ rapid growth healthy?

- The Hindu BusinessLine 03/09/19, 10(47 AM

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Is equity derivatives’ rapid growth

healthy?
Lokeshwarri SK | Updated on April 10, 2019 | Published on April 10, 2019

It is if retail investors’
interests are
protected. Setting
trade limits based on
their education,
income and
experience will help
Derivatives provide a channel for hedging risk - Mario13 Investors have been up in
arms over the last couple
of years due the Securities and Exchange Board of India’s
! SHARE " SHARE # SHARE
proposal to restrict retail participation in the derivative
segment. The regulator is concerned that naïve investors
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MAAIILL % SHARE & C
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MMMEEN
NTT
are being mis-sold these products by intermediaries and
thus exposing them to capital risk. The other issue that
RELATED has been drawing attention is the burgeoning turnover in
the equity derivatives segment.

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Is equity derivativesʼ rapid growth healthy? - The Hindu BusinessLine 03/09/19, 10(47 AM

95% equity F&O It was the SEBI discussion paper on ‘Growth and
traders are Development of Equity Derivative Market in India’,
professional HNIs: released in August 2017, that set the cat among the
Limaye pigeons. There were two focal points in the paper — one,
the trading in derivatives compared to cash market in the
Indian market was the highest globally and, two, retail
investors accounted for a large chunk of trading in
derivatives and they were dabbling in relatively riskier
instruments.
Stock exchanges
racing towards Let’s examine these two points.
shared clearing
operations by Cash-to-derivative ratio
June 1
The SEBI discussion paper had pointed out that the ratio
of the turnover in the equity cash segment to equity
derivative segment had risen to 15.5 times in 2016-17,
from 1.54 times in 2004-05. This is considered unhealthy
as the function of derivatives is to provide a channel for
hedging risk. An unusually high ratio could, therefore,
point towards excessive trading and speculation. But it
would be wrong to jump to conclusions based on the
above numbers. There are various reasons why the
numbers do not paint the true picture.
One, option trades dominate Indian derivatives,
accounting for over 80 per cent of turnover. Since value
of the option contract is used for computing the turnover
and not the premium, the turnover tends to get bloated.
If the turnover is computed based on option premiums,
the ratio reduces to around three times, in line with other
global exchanges.
Two, the entire equity derivative trading takes place on
exchange platforms in India, whereas a bulk of the
derivative turnover in other countries are conducted in
OTC markets and hence not included while computing
the ratio.

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Is equity derivativesʼ rapid growth healthy? - The Hindu BusinessLine 03/09/19, 10(47 AM

Three, there are certain regulatory and structural

inefficiencies in the Indian cash market that are leading
to fast-paced growth in derivatives.
Naked short-selling in the equity cash segment was
banned a few years ago, forcing those who wish to hedge
short-term risks to the derivative segment.
Single stock futures are not as popular elsewhere in the
world, and the demand for these instruments in India is
due to the inability to short-sell in the equity cash
segment. Higher securities transaction tax levied in the
cash segment of equity is another reason commonly cited
for depressing growth in cash turnover, while providing
an impetus to derivative turnover.
Four, lack of liquidity in future and options contracts
beyond one or two months can also lead to a skew as
another new contract needs to be bought as positions are
rolled over, thus increasing the multiple.
Also, as many option strategies involve purchase of two
to four contracts to hedge one corresponding position in
the cash market, the ratio can increase correspondingly.
Demographic shift
Besides the above, few other factors have also been
instrumental in growing the Indian derivative market.
Commodity derivatives have been out of favour since
2013, due to the scam in NSEL and the introduction of
commodity transaction tax. A bulk of these trades could
have migrated to equity derivatives.
Financialisation of Indian savings with shift from real
assets such as property and gold towards financial assets
such as bank deposits, equity, and mutual funds is
another reason, as those with a relatively larger risk
appetite would have started dabbling in equity
derivatives as well.

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Is equity derivativesʼ rapid growth healthy? - The Hindu BusinessLine 03/09/19, 10(47 AM

The rise in derivative turnover can also be partly

attributed to improved life expectancy in the country and
better health among those over 60 years of age. Many
retirees have now taken to trading as they can do it from
home, requires minimal capital outlay, and does not take
too much of their time.
Besides retirees, many in the younger age-brackets are
also opting for full-time trading as it provides them a
stable income source. Increasing awareness and growing
acceptance of full-time trading as an occupation could
also be contributors.
Retail participation
That brings us to the next question: Is retail participation
in equity something to worry about? If the turnover in
equity futures and options is considered, around 45 per
cent originates from clients. Of this, companies and
partnerships account for 15-20 per cent, leaving about 25
per cent for individuals.
Now, it is not possible to classify all individuals trading in
derivatives as small or retail investors. Data from the NSE
show that around 50 per cent of individual investors
trading in derivatives transacted more than 10 lakh
worth of shares in the cash segment in a year. Twenty-
three per cent of these individuals traded more than 1
crore in cash market, while 8.5 per cent traded more than
50 lakh. Only one-third of individual investors
transacted less than 10 lakh.
The moot question is whether individual investors who
are well informed and can find their way to riches
through stock derivatives should be barred just because
they do not meet the net worth criteria?
The way out

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Is equity derivativesʼ rapid growth healthy? - The Hindu BusinessLine 03/09/19, 10(47 AM

A balance needs to be struck between allowing retail

investors the freedom to trade derivatives while
protecting them. Globally, many exchanges follow
product-suitability frameworks for allowing retail
investors to trade in derivatives. These are based on their
minimum income or net worth, education, experience in
trading and level of due diligence by stock brokers.
SEBI has currently prescribed exposure of individuals
based on the disclosed income as per the ITR over a
period of time. Any exposure beyond the computed limit
can be allowed by the intermediary after rigorous checks.
Using the income criteria alone to allow investors into
derivatives does not seem right as many of them might
have been dealing in the securities market for many
years. Working out a limit based on education, income
and experience may be a better idea. Also, while brokers
are required to do due diligence and explain the risks to
investors, often, this is a mere formality, with clients
signing on the dotted line without reading the fine-print.
Intermediaries need to be sensitised to carry out their
duties better.
Finally, addressing the anomalies in the cash market and
removing the regulatory arbitrage between equity cash
and equity derivatives can help reduce the turnover
differential between the cash and the derivative market.
Published on April 10, 2019
futures and options SEBI
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