By Prashant MaheshThere is no denying the fact that the Indian stockmarkets have come a long way. From the open outcry ring trading system, which used to witness multi-million deals struck in a mere couple of hours, today deals are struck via computers.
A step ahead
Trading hours have increased, as has transparency. This has led to greater investor interest too, both among individuals and institutional investors. From a time when dabbling in stocks was the bastion for a chosen few, today things are so simple that even a common man can trade on the markets.In terms of systems too, things have changed. With international money coming in, slowly and steadily, the Indian markets are moving towards achieving international standards. Hence, the urgency to have a proper hedging facility in place is heightened. True, the badla system is there, but it facilitates only individuals. The institutions too require a facility to allow them to hedge against the movements in the stockmarkets. Players claim that a proper hedging system would help catalyse higher volumes on the Indian bourses.
The germ
The proposal to introduce derivatives’ trading on the Indian stock exchanges was mooted in 1996. But then the two premium bourses, the Bombay Stock Exchange (BSE) and the National Stock Exchange NSE) were archly pitted against each other. The older BSE had the badla hedge, and was opposed to the introduction of derivatives’ trading.
On the other hand, the NSE, positioning itself as an international exchange, did not go for badla and maintained that it would introduce a hedging system meeting international standards. The stalemate has persisted what with unstable political conditions leading to governments falling at the drop of a hat. All this has meant that the much-awaited decision on derivatives’ trading has been getting postponed.
Today though, things are quite different. There is some semblance of political stability that appears to last for longer time. Consequently, there have been developments at the bourses too.
Four years back, without computerisation, the ring system was hardly transparent enough for the institutional investors to take to it. Settlement periods were longer as compared to the T+3 system prevalent in the US markets then. There was no depository.
Institutions had to compulsorily deal in physical paper, which meant delay in transfers and massive problems of bad delivery of shares. This system penalised the buyer for no fault of his own. Often, after the payment for purchase of shares, the buyer had to wait for months for delivery with a clear title. Naturally, this problem alone prevented the foreign institutional investors (FIIs) from foraying into the Indian stockmarkets.
The metamorphosis
Things are very different today. Technology has allowed for the stock exchanges to have a far greater reach, and the Internet promises to maintain this advantage. The turnover too has vaulted -- daily combined turnover on the two premier stock exchanges (BSE and NSE) has crossed Rs 8,000 crore.
Market capitalisation has also increased making it difficult for the markets to be manipulated by any single individual. Delivery-based trading has risen, and with rolling settlements just introduced it is likely to increase even further.
Many agree that in 1996 the FIIs greatly influenced the markets. On the domestic front, UTI was the lone financial institution worth talking of.
Now this scenario is much different. The last couple of years have witnessed some spectacular performance by the domestic mutual funds. As such, if the mutual funds sustain their good performance, investor confidence could be reposed and investors will come back to mutual funds. This of course will strengthen the domestic mutual funds industry largely.
In fact, former president of the BSE, MG Damani expects mutual funds to mop up as much as Rs 30,000 crore to Rs 40,000 crore per year overall through a combination of debt, equity, balanced or even sectoral funds. Damani sums it up succinctly when he asserts, " Any country with its own strength is definitely better placed be it politics or the capital markets. Today, our financial institutions have their own research, collective strength and, financial strength."
Can the new structure support derivatives?
The Indian markets have then come a long way from where they were three years ago. The question then: is now then the opportune moment to introduce derivatives on our bourses?
Definitely, circumstances could never have been more ideal than now. But, a base has to be been built up. Says a member of the BSE, Alok Churiwala, "It ha to start at one point of time or the other. Just like a plant needs soil, water and minerals to nuture well, for derivatives you need a healthy cash market in place."
Today, the cash markets are much better than they were in the 1996. However, one area where systems development has not taken place is in the banking sector. The banking sector has been slow in technological compliance, which could prove to be a stumbling block in the introduction of further derivative products.
Currently, electronic transfer of funds is not possible in India, which cramps liquidity and thus volumes. In stock index futures trading, client operations are marked to market on a daily basis. This means daily account adjustments and cash flows. Unable to transfer funds within twenty-four hours, a broker could be strained. To counter this, he may probably ask the client to pay a higher margin upfront, which means a further drop in liquidity.
Alok Churiwala says, "To synergise with the rest of the world, it is imperative to start transferring funds electronically. Starting derivatives would only highlight the need for transfer of funds."
To begin with, at least banks in major metros like Mumbai, Delhi, Calcutta and Ahmedabad, from where most of the derivative volumes are expected to come, should be inter-linked. However, others like Kotak Securities' associate vice president, Keyur Majumdar is optimistic when he says, "HDFC Bank is the leader in the banking sector. With it also being a part of the clearing house, it is likely that electronic transfers, at least within the city, could happen very soon."
Another hurdle is absence of an active debt market. MG Damani says, "Time and again we have made representations to the RBI, but we did not get the requisite permission." For the arbitrageurs, a liquid debt market is of paramount importance to park funds for the short-term period and to use it whenever appropriate. The BSE has been pursuing for a retail market for debt. But, all its efforts have been in vain as the RBI has not given the go ahead. Hence, a change of mind by RBI could provide that extra fillip to the derivative market.
Stock index futures: The product
Unlike the cash market, trading in derivatives is purely speculative and cash-based without delivery. The Indian stockmarkets are introducing stock index futures. While the BSE plans to start off by trading on the Sensex, the NSE would start off by trading on the Nifty.
Internationally, stock index futures are widely popular. In the Indian context too, they make a lot of sense on the following grounds:
Institutions and other large equity holders need a portfolio hedging facility. For them, index-based derivatives are more suitable and cost-effective than derivatives based on individual stocks. Even pension funds in the USA use stock index futures for risk hedging purposes.A stock index is much harder to manipulate than an individual stock. This is partly because an individual stock has limited supply, which can be cornered. Of course, a stock index could be manipulated through the cash prices of its component securities. But this is much more arduous and capital-intensive. Huge market capitalisation makes it a practical folly, if not an impossibility.Stock index, being an average, is less volatile than individual stock prices. Lower volatility means lower margins and capital adequacy requirements than in case of derivatives on individual stocks. Lower margins will induce more players to participate.Popularity of stock index futures ensures a high degree of liquidity.In the case of individual stocks, outstandings on the expiry date has to be settled by physical delivery, as per the accepted convention. But since the Index futures do not represent a physically deliverable asset, they are cash settled all over the world on the premise that the index value is derived from the cash market. This, of course, implies that the cash market is functioning in a reasonably sound manner and that the index values based on it could be safely accepted as the settlement price.Regulations are likely to be simpler for the stock index futures than for other kinds of equity derivatives, such as stock index options or individual stock options.Who constitutes the market?
Players in derivatives differ in their views on the introduction of derivatives in the Indian markets. While NSE officials say that index-based trading will attract many individual players, there are others who tread caution. An investor should know about the new product before actually starting off.
Says Keyur, "There will be three types of players initially namely, the hedgers (the FIs), high net worth individuals or speculators and the arbitrageurs." Considering the speculative nature of the product, individual investors are definitely expected to join in. It is for the regulatory authority, the Securities & Exchange Board of India (SEBI), to decide on such participation.
Secondly, the sales staff at the brokers would have to be extremely careful about how they market this speculative product. For instance, in markets like Taiwan when stock index futures were first introduced, the small investors were disallowed from participating. But currently, with the bulls in full action in the Indian markets, the small investor would definitely like to participate. In fact, the LC Gupta committee report mentions that 70 per cent of the people who lose money in derivatives’ trading are the small investors. This, because individual investors find making a call on the index much easier. The mutual funds would rather use this product as a hedging instrument. The stock exchanges, for their part, would rather concentrate on the safety of a trade.
The exchanges are likely to levy an initial margin plus a daily mark to market margin along with additional volatility margins if any, as and when required. While the stock index futures on the S&P 500 carry an initial margin of 6.5 per cent, the final modalities in the Indian context have still to be worked out. Since electronic transfer of funds is not possible, in all probability, this margin could be slightly higher here.
As for investor education, both the NSE and BSE have started certification tests for its brokerage staff members. The BSE and NSE together have certified more than 3,000 individuals. This "army of individuals" is expected to educate individuals and investors about the product.
The future
Stock index futures would herald a new chapter in the history of the Indian stock markets. Its success would depend on the level of institutional participation, their approach to the product and so on so forth.
Initial circumspection apart, once the markets are convinced about the product, a series of other products could be lined up. In fact, many would be interested in an infotech index. Slowly but steadily, India is definitely moving ahead to get aligned with the world markets.
Meanwhile, one would assume derivatives being speculative in nature could have little impact on the economy. But then as IGIDR's Ajay Shah says, "At the macro level, a well-functioning derivatives’ market will improve efficiency of the underlying cash market. It will improve the markets' ability to direct resources towards projects and industries where the rate of return is the highest. By improving the allocative efficiency, a given stock of investible funds will be better used in procuring the highest possible GDP growth in the country."
Well this is something that everyone has been looking for.