 |
A bull-market in Indian equities last year sparked spectacular growth in the country’s equity derivatives market, which began trading four years ago. Monthly turnover in equity derivatives grew almost fourfold last year and in February this year it accounted for two-and-a-half times the spot cash market turnover on the National Stock Exchange (NSE).The average daily equity derivatives turnover in January touched Rs150 billion (more than $3 billion).
The Indian stock market had emerged from a bruising crash caused by over-leveraged positions when equity derivatives were first introduced, and there was apprehension over whether the Indian securities market was ready for them.
The Indian derivatives market trades in stock and index futures and options. Over 95% of derivatives trading takes place on the NSE.
Curiously, single-stock futures are the most popular product on the NSE, accounting for 60% of derivatives turnover. They are available on 53 stocks that trade on the NSE and around 45 stocks that trade on the Bombay Stock Exchange (BSE).
Index-based products are generally more popular in most developed markets, with perhaps the exception of a few such as Spain where single-stock futures are actively traded.
Among Asian countries, India stands out alongside Korea for the high level of retail interest in derivative products. This enthusiasm generates large volumes, finer prices and reduces the cost of trading; and Indian markets’ risk systems have stood the test even when the markets turned volatile, say Barun Agarwal and Rajendra Nair, futures traders at JPMorgan.
Attraction for small investors
The Securities and Exchange Board of India (SEBI), the market regulator, plans to halve the size of a derivative contract to Rs100,000 ($2,222), and the NSE introduced contracts based on its IT index last year, encouraging more small investors to participate in the market.
Indian investors have no trouble using stock futures, because for years they used badla, a homegrown stock futures product. Badla enabled its users to take a view on a stock in the cash market and helped them carry forward a trade to the next settlement by paying a margin.
Badla flourished on the BSE when transactions in the market were settled once a week but got outdated as Indian markets adapted to global settlement standards, going from T+5 in 2001 to T+2 in April last year.
Traders now say trading in futures is far safer than badla because margins must be paid before a trade is executed.
The separation of the cash market from the derivatives market allowed speculators to move to the futures market. Also, institutional investors, who were barred from badla trading, can now participate in the derivatives market.
Foreign institutional investors account for just under 3% of the turnover in the futures and options market, but their share of the open interest in derivative contracts has doubled in the past year to around 20%.
Foreign investors, however, dislike the restrictions imposed on them. The exposure of a foreign portfolio investor to an index product is restricted to 15% of the open-interest position of all index-based contracts, or Rs1 billion (around $22 million), whichever is higher. The limit for single-stock futures product is 20% of the market-wide limit or Rs500 million, whichever is the lower.
Andrew Holland, head of research at DSP Merrill Lynch, says easing the limits will allow for greater participation by foreign portfolio investors. A wider set of investors will provide finer prices, add more depth to the market and eventually allow more derivative products to be introduced.
Equity index-based products are likely to become more popular as institutional investors become more active in the market, says Jayant Varma, a former member of the board of SEBI, who helped frame rules for the derivatives market in India.
At present, all equity derivative contracts must be settled in cash. For the market to evolve more fully, investors must have the option to settle derivative contracts in the underlying stocks.
As a step towards that, the market regulator recently introduced a scheme for stock lending and borrowing. Institutions are natural lenders of securities, but possibly need some form of insurance protection before they get active in the market, says UR Bhat, head of equity at JPMorgan.
