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Heightened volatility in the equity market has resulted in record volumes in equity futures and options traded on the NSE this calendar. This has increased the divergence in turnover between the cash and derivative segments. Retail investors, who account for a chunk of derivative trading, could face higher risks in this situation.
The notional turnover of futures and options traded in October 2018 on the NSE — accounting for almost all the equity derivative trading in India — was 53 per cent and 158 per cent higher, respectively, over the same months in 2017 and 2016. The daily turnover averaged ₹11-lakh crore this October compared to ₹2-lakh crore three years ago.
Volumes in the cash segment are growing at a far slower pace. Cash turnover in October 2018 in equities was 5 per cent and 65 per cent higher than in the same month in 2017 and 2016 respectively. The faster growth in derivatives has resulted in shrinking the share of the cash segment in total equity trades on exchanges to just 3 per cent now, compared to around 10 per cent three years ago.
Raising concerns about this skew, SEBI has been trying to increase the link between cash and derivative trades in equity by proposing physical delivery of stock futures. According to a SEBI report, the ratio of equity derivative turnover to equity cash turnover had widened from 3.2 in 2009-10 to 15.59 in 2016-17. A BusinessLine analysis shows that this ratio has deteriorated further to stand at 26.4 in 2018-19.
This widening ratio is a cause for concern as it indicates growing speculative activity. The role of derivatives is to help hedge risks in the cash segment, and hence the derivative turnover cannot be disproportionately higher. While it can be argued that the disparity reduces if the option premium turnover alone is considered, the Indian market sports the highest divergence even if the option premium turnover is used for computing the ratio, according to SEBI.
Category at risk
Category-wise turnover data released by the NSE show that proprietary trading by brokers contributes about 40 per cent to the equity derivative turnover and FPIs account for around 12 per cent. ‘Others’ contribute the largest chunk to the turnover — around 48 per cent.
SEBI-appointed LC Gupta Committee had pointed out that individual investors form a large part of the non-institution category and could account for 25.67 per cent of the total equity derivative turnover. These investors typically have limited capital and are more vulnerable in market downturns.
The committee also found that individual investors are more active in index and stock futures. While futures are less complex, they are riskier compared to options where the maximum loss is contained to the extent of the premium paid.
Checks needed
The recent proposal by SEBI to restrict trading by individual investors based on their disclosed incomes — as per their I-T returns — can be a way to protect them. The Gupta Committee had pointed out that broker-client relationship and sales practices in selling derivatives need a review, as it is possible that individual investors trading these contracts may not be fully aware of the risks.
While intermediaries are up in arms against this proposal, as it will involve a greater compliance burden, the regulator appears determined to push it through.
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