“The stock market in India is among the largest casinos, due to the ‘cash settled’ derivative system of trading,” DR Mehta, former chairman of SEBI told BusinessLine . SEBI on Monday said it will move all derivative stocks to compulsory ‘delivery-based’ or ‘physical settlement’ in a phased manner in 2019 and replace the in-vogue ‘cash settlement’ system.

Equity derivatives were introduced under Mehta, SEBI’s first chairman between 1995 and 2002. Mehta had strong views against ‘cash settled’ derivatives but was accused by many of blocking progress of the NSE under influence from the rival bourse.

Equity derivatives were introduced in 2001, just a year before Mehta retired. The real push for the segment though came after 2004 following P Chidambaram taking over as Finance Minister in the UPA government, as a series of policy measures shifted cash volumes to derivatives until a 2017 study raised the alarm.

SEBI and the government were rattled as the study showed India’s emergence as the second-most speculative equity market globally — due to derivatives trading — after South Korea. Equity derivatives turnover to cash segment turnover stood at 15.2:1. That is, more than 15 trades in derivatives for a single cash market trade. A culture of excessive speculation seeped in as algo and computer trading strategies thrived at the cost of retail investors.

Nearly 16 years after his retirement, Mehta, now 80, has a series of questions for market ‘pundits’.

“Who has benefited from cash settlement? Where is Ajay Shah, chief proponent of the cash derivative market? Where are investors who were supposed to come in droves with such reforms?

Mehta, who moved out of SEBI on attaining retirement age, says the LC Gupta Committee appointed by him to study derivatives trading, had suggested a shift to delivery-based derivatives soon after the initial phase. “Gupta, who was a strong proponent of derivatives too, studied it deeply and changed his views drastically and came to the conclusion that markets would turn into a casino if appropriate measures were not taken in future. We had to move with reforms and derivatives were introduced with the anticipation that physical settlement may follow,” said Mehta.

Mehta believes there was a lack of understanding on delivery in derivatives as most believed it came close to the erstwhile ‘Vyaj Badla.’ Vyaj meant interest in Gujarati and Badla was settlement. Brokers financed borrowers of stocks, who wanted to carry forward their positions, but had to give delivery of stocks. Badla got a bad name as defaults piled up due to off-market deals.

New derivative contracts were çash-settled; these did not involve the evil of Badla, but it opened up a new vista for manipulation.

Under cash system no delivery of shares is required and settlement of carry forward position or square-off is done by paying the difference in strike price and value of underlying security. But it has come under the control of moneybag cartels, who play without the fear of having to give any delivery of shares. The buyer of cash settlement futures option is not buying any underlying stocks or a basket of stocks in case of index, but merely an option to buy at a future date, which he will never do. Hence, ‘cash settled’ futures transactions imply no ownership obligation.

Under the delivery system, if speculators artificially increase or suppress the derivative price, the counter-party can ask for the shares. Large players such as LIC can participate in the derivatives segment and limit the power of foreign cartels.