July 28, 2015
Trading in derivatives far outstrips that in equities and is largely speculative. Sebi is taking steps to check this
Earlier this month, the Securities and Exchange Board of India (Sebi) raised the minimum contract sizes of equity derivatives from ₹ 2 lakh—a limit that was set in 2000—to ₹ 5 lakh. In an earlier column in this paper (“Reduce speculation in derivatives to bridge trust deficit”, 9 September 2014), we had argued by using data from Sebi and the stock exchanges that India’s equities markets are distinctly speculative in character and are dominated by retail and small traders speculating heavily through equity derivatives.
India’s derivatives market is 15 times larger than its cash (shares) market, the highest ratio in the world by a wide margin. Domestic retail investors and proprietary traders account for 87% of all derivatives trading in India. The notional value of such trading touched $1.3 trillion in 2014-15, from just $40 billion a decade ago. Recall that derivatives are inherently a leveraged bet on stock price movements with margin financing.
In this context, the recent move by the market regulator is laudable, coming as it does against the backdrop of the recent volatile gyrations of the Chinese equities market that threatens to be the cradle for the next global financial crisis.
Fortunately for Sebi, there is a parallel in Asia from which it can draw meaningful lessons. South Korea, similar to India today, had an inordinately outsized derivatives market, dominated by retail speculators until 2011. In 2012, the Korean regulator increased the size of its derivatives contracts, much to the chagrin of traders and the stock exchange.
In 2011, nearly four billion index derivatives contracts were traded in Korea for a notional value of $100 billion. By 2014, it was down to nearly 1/10th—500 million contracts—with a notional value of $54 billion, down 42% since 2011. However, it had no impact on cash market volumes. They maintained their steady long-term trend.
The Korean regulator’s decision to increase contract size amid other policy changes introduced at that time has had its desired impact in curbing derivatives trading activity with little effect on share trading volumes or capital-raising activities in the Korean equity market. Sure, derivatives volumes collapsed by 50% in the first year after these measures, but over the longer run, it seems to have had the optimal outcome in terms of curbing speculative activity using derivatives without any negative impact on the primary and cash markets.
Some argue that Sebi’s relatively small increase in contract size from ₹ 2 lakh to ₹ 5 lakh may not be sufficient for a meaningful marginal impact. However, it surely is a signal that Sebi is cognizant and desirous of raising contract sizes to curb small investor participation in derivatives. Sebi should continue to signal to the market that it will monitor excessive derivatives activity closely and not be shy of increasing minimum contract sizes further.
While Sebi has fired its first salvo against this derivatives menace in the Indian equities markets, it is time for the finance ministry to follow it up by plugging the bizarre securities transaction tax (STT) structure that overtly and wrongly incentivizes speculation over investment. STT on capital market transactions was introduced in the budget speech of 8 July 2004, to compensate for the loss of tax revenues from the elimination of long-term capital gains tax in equities. STT for buying shares is 0.1% while it is zero for buying futures or options.
This is a perverse incentive and it is time for the finance ministry to plug this hole by bringing parity in STT in both shares and derivatives. While it is legitimate to argue that long-term capital gains tax exemptions are incongruous for a developing country such as India, we already have zero taxes on long-term capital gains and an STT regime already in place. It is easier to neutralize perverse incentives for speculation by equalizing net STT for buyers of both shares and derivatives.
Critics of Sebi’s intervention in the equity derivatives markets have typically argued along the lines of Jimmy Carter’s maxim of “if it ain’t broke, don’t fix it” or by casting it as an illiberal measure. In the aftermath of the financial crisis of 2008, arguing that policymakers should only react and not be proactive is like saying that India had to experience its own 9/11 incident before implementing stricter airport security measures.
The simple truth is that derivatives are a complex product intended as a hedging tool for sophisticated investors. As much as 85% of the Indian derivatives market is made up of retail investors and proprietary traders. Instead, it should largely consist of sophisticated institutional investors, who presumably need to use derivatives more to hedge their large holdings.
By increasing the minimum lot sizes of derivatives, Sebi has created a better trade-off for these retail investors and traders.
Exhorting Indian households to invest in Indian capital markets away from gold and attempting to bridge the so-called trust deficit through investor education seminars and events is simply not enough.
It is important to recognize that a speculative capital market will suffer from an adverse selection problem and primarily attract other speculators, scaring away potential first-time investors. Restoring the balance between investment in shares and complex derivatives trading is an important step in letting stock markets have a purposeful role in the economy. Sebi has taken that step.
Sebi and the finance ministry still have to do more to ensure that Indian capital markets finance genuine capital formation and economic development and not serve as casinos.
Praveen Chakravarty, V. Anantha Nageswaran and Ajit Ranade are, respectively, a visiting fellow at IDFC Institute, a Mint columnist and chief economist at Aditya Birla Group. These are their personal views.