ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Domestic Derivatives: Issues, Risks and Proposals

The National Stock Exchange has overseen an enormous growth in derivatives trading. However, this amazing growth, driven largely by retail demand, camouflages two major weaknesses in the nature of its structure and profile of the investors (who are limited in number). These two weaknesses have given rise to a number of other issues such as sustained volatility in the equity markets, shallowness and increased concentration.


Domestic Derivatives: Issues, Risks and Proposals

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Economic and Political WeeklyMarch 31, 20071075The impact of the introduction of stockfutures was felt immediately. Earlier, thedaily average derivatives segment volumeincreased slowly from Rs 116 crorebetweenJune 2000 and March 2001 toRs2,608 crore in October 2001, after theintroduction of the three instruments, butin the next month following the introduc-tion of stock futures the turnover jumpedto Rs 4,380 crore and thereafter it hascontinued to rise to Rs 31,373 crore inJanuary 2007, a 600 per cent increase insix years. The introduction of stock futuresand the consequent surge in the derivativessegment volumes have catapulted the NSEinto the first position among the globalexchanges.Badla through the Backdoor: The unusualsuccess of stock futures has been to anextent attributed to its similarity to theearlier ‘badla’2system and the market par-ticipants who earlier participated in badlaare now active in stock futures. In stockfutures trading, the investors pay only asmall margin and, hence they are in aposition to hold large leveraged positions.The opportunity to hold leveraged posi-tions makes it possible for speculators tomanipulate stock futures.Issues in Settlement Mechanism:L C Gupta(2006) opines that the dominance of stockfutures is the most important architecturalweakness, which emanates from its settle-ment mechanism. At the time of its intro-duction, it was envisaged that a system ofphysical settlement would be in place withinsix months. Even after six years of itsoperations, physical settlement is stillawaited. Physical settlement imposes arestriction on the market participants, giventhe short supply of shares in the spot marketand thereby induces discipline. But, in thecase of cash settlement, this restriction isdone away with, as the supply of cash doesnot pose any such restrictions. L C Gupta(2006) also argued against the allowing ofFIIs into trading in stock futures. How-ever, there were others who believed thatphysical settlements would increase thepossibility of a bear squeeze, especially inscrips where the floating stock was low.In a bull market, the floating stock avail-able on a daily basis shrinks rapidly eventhough trading volumes on the boursesappear high. It was perceived that intro-duction of derivatives trading wouldencouragearbitrage between derivativesand cash markets, and thereby assist pricediscovery process.Even Deena Mehta (2005), former presi-dent of BSE, argues that the absence ofphysical settlement in derivatives allowsinvestors to hold large positions and rolloverof the same at the time of deliveries therebypushing up stock indices. She further saysthat the country takes great pride in fol-lowing international best practices but inall developed countries, derivative tradesare delivery settled. Emphasising this pointfurther, R H Patil (2006), chairman of theClearing Corporation of India, argued:Most of the countries that have introducedequity futures have preferred to introduceindex futures, and options in index andindividual stocks. Very few countries havetaken the risk of introducing individualstock futures. Even in those countries wherethe individual stock futures have beenTable 5: Daily Volatility in the Indices(In per cent)USA DowUSAUKHong KongMalaysiaSouthThailandSingaporeGermanyFranceIndonesiaBSES and PJonesNASDAQFTSEHISKLCIKoreaSETSTIDAXCACJCISensexCNX NiftyComp100KOSPI1234567891011121314April0.580.740.860.550.391.031.070.440.820.751.011.61.66May0.80.941.531.320.611.471.321.41.551.542.552.552.77June0.921.361.111.320.61.821.521.41.391. Volatility(April-December)8.712.711.613.17.615.123.6131413.618.724.825.1Source: Bloomberg Financial Services.Table 6: Institutional Retail and Proprietary Investors – Turnover AnalysisNoMonthsInstitutional InvestorsRetailProprietaryGross TradedPercentageGross TradedPercentageGross TradedPercentageValueContributionValueContributionValueContribution(Rs in Crore)(Rs in Crore)(Rs in Crore)1Jan-2005322916.129957756.519871137.52Feb-2005282235.629756258.718131835.83Mar-2005376906.335519259.420483234.34Apr-2005348668.922166856.613540434.65May-2005358288.623910457.414182834.06Jun-2005405137.532157559.318040433.37Jul-2005432847.037753261.319551731.78Aug-2005560757.545052660.523801432.09Sep-2005555757.049375061.825018731.310Oct-2005679617.851930259.928005832.311Nov-2005563407.149208662.224328030.712Dec-2005657866.365511062.532671931.213Jan-2006742157.661635063.228460329.214Feb-2006823888.462412263.327883528.315Mar-20061036357.197117166.239389226.816Apr-20061203548.291503162.044029329.817May-20061422509.688647859.745607530.718Jun-200611177910.065205258.634977731.419Jul-2006948519.955729258.430236631.7

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