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B. Venkatesh

Recent media reports suggest that SEBI’s proposal to allow short-selling in the spot market may be a prelude to introducing a delivery-based design in the derivatives market.

This article argues that SEBI should not take such a measure, at least for now. A delivery-based design in the current market structure will leave only the institutions and HNIs trading in derivatives. That will push a substantial proportion of noise trading to the spot market, leading to a disconnect between the two markets. This would distort price efficiency, confounding hedgers and traders.

It would be optimal if a uniform contract size of 100 is introduced in the derivatives market and measures are taken to lower market manipulation before an attempt is made to switch to a delivery-based market design.

Take Ranbaxy. A short futures position will entail delivery of 800 shares on the last day of expiry of the contract in a delivery-based market design. Likewise, a short call option will require delivery of 800 shares if the buyer chooses to exercise her right on any day during the life of the contract. At the current price, the delivery will cost around Rs 3.5 lakh. Such large cash outlay could push retail investors away from the derivatives market.

A market with minimal retail participation has its problems. For one, substantial proportion of noise trading will shift to the spot market. That could lead to a disconnect between the two markets, as the derivatives market will trade primarily on “information” and the spot market will be driven more by noise. Such disconnect could undermine asset price efficiency, not improve it.

For another, institutions and HNIs are “informed” traders. It is moot if abnormal trades would be met with suspicion of asymmetric information, or what George Akerlof calls the “market for lemons”.

Some argue that retail investors can continue to trade in futures and close their positions before the penultimate day. That way, they can avoid having to honour delivery requirement. The intention behind shifting to a delivery-based design is to encourage delivery. Expecting the retail investors to close their positions seems counter-intuitive.

There seems no compelling need to introduce a delivery-based market design now. A cash-settled market design has been continued for so long because of worries about market manipulation. What if an “operator” cornered substantial shares in the spot market and began buying call options or futures as well? The short-call or short-futures position will run a high delivery risk — the risk that price could move against the position on the delivery date due to short-squeeze.

The market structure has not changed much to switch to delivery-based market design. Allowing short-selling in spot market and cobbling up a stock-lending mechanism does not reduce price manipulation; the “rent” for cornering shares in the spot market will be collected through high lending rate from short-sellers.

The need for a delivery-based design has arisen because of the belief that the current market design does not encourage active participation from hedgers. That is not so. Participants do not hedge because of non-availability of long-dated derivatives contracts. Importantly, a cash-based market design does not necessarily deter the hedging process. Here is why.

Suppose a portfolio manager has to fold her fund in one year. Assume that one-year futures and options are available in the market. The portfolio manager can sell index futures if she wants to lock-in to the profits now. She may choose to buy index puts if she wants to protect their downside risk without sacrificing upside potential.

In a cash-based market design, the short position in the derivatives market will generate profits if asset prices decline. The profit from the hedge can be used to offset the losses in the portfolio. The argument here is that the portfolio manager has to now sell the shares to fold the fund. And that could lead to a high impact cost.

The argument is correct but does not consider the possibility that the portfolio manager could gradually sell the holdings as the fund nears expiration and simultaneously lift the hedge. That way, the impact cost will be minimal.

It is not as if a delivery-based market design does not suffer any cost. There is the carry-cost for shares that needs to be delivered against the short position. The short-seller is likely to price that into derivatives contract. And that price will not be substantially lower than the impact cost.

The NSE newsletter shows that less than 3 per cent of futures positions are carried to the last day of expiry. It is unlikely to be any different with a delivery-based market design, as the cash outlay to honour delivery will be very high. So, why shock the market microstructure now?

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