Investors have been up in arms over the last couple of years due the Securities and Exchange Board of India’s proposal to restrict retail participation in the derivative segment. The regulator is concerned that naïve investors are being mis-sold these products by intermediaries and thus exposing them to capital risk. The other issue that has been drawing attention is the burgeoning turnover in the equity derivatives segment.

It was the SEBI discussion paper on ‘Growth and Development of Equity Derivative Market in India’, released in August 2017, that set the cat among the pigeons. There were two focal points in the paper — one, the trading in derivatives compared to cash market in the Indian market was the highest globally and, two, retail investors accounted for a large chunk of trading in derivatives and they were dabbling in relatively riskier instruments.

Let’s examine these two points.

Cash-to-derivative ratio

The SEBI discussion paper had pointed out that the ratio of the turnover in the equity cash segment to equity derivative segment had risen to 15.5 times in 2016-17, from 1.54 times in 2004-05. This is considered unhealthy as the function of derivatives is to provide a channel for hedging risk. An unusually high ratio could, therefore, point towards excessive trading and speculation. But it would be wrong to jump to conclusions based on the above numbers. There are various reasons why the numbers do not paint the true picture.

One, option trades dominate Indian derivatives, accounting for over 80 per cent of turnover. Since value of the option contract is used for computing the turnover and not the premium, the turnover tends to get bloated. If the turnover is computed based on option premiums, the ratio reduces to around three times, in line with other global exchanges.

Two, the entire equity derivative trading takes place on exchange platforms in India, whereas a bulk of the derivative turnover in other countries are conducted in OTC markets and hence not included while computing the ratio.

Three, there are certain regulatory and structural inefficiencies in the Indian cash market that are leading to fast-paced growth in derivatives.

Naked short-selling in the equity cash segment was banned a few years ago, forcing those who wish to hedge short-term risks to the derivative segment.

Single stock futures are not as popular elsewhere in the world, and the demand for these instruments in India is due to the inability to short-sell in the equity cash segment. Higher securities transaction tax levied in the cash segment of equity is another reason commonly cited for depressing growth in cash turnover, while providing an impetus to derivative turnover.

Four, lack of liquidity in future and options contracts beyond one or two months can also lead to a skew as another new contract needs to be bought as positions are rolled over, thus increasing the multiple.

Also, as many option strategies involve purchase of two to four contracts to hedge one corresponding position in the cash market, the ratio can increase correspondingly.

Demographic shift

Besides the above, few other factors have also been instrumental in growing the Indian derivative market. Commodity derivatives have been out of favour since 2013, due to the scam in NSEL and the introduction of commodity transaction tax. A bulk of these trades could have migrated to equity derivatives.

Financialisation of Indian savings with shift from real assets such as property and gold towards financial assets such as bank deposits, equity, and mutual funds is another reason, as those with a relatively larger risk appetite would have started dabbling in equity derivatives as well.

The rise in derivative turnover can also be partly attributed to improved life expectancy in the country and better health among those over 60 years of age. Many retirees have now taken to trading as they can do it from home, requires minimal capital outlay, and does not take too much of their time.

Besides retirees, many in the younger age-brackets are also opting for full-time trading as it provides them a stable income source. Increasing awareness and growing acceptance of full-time trading as an occupation could also be contributors.

Retail participation

That brings us to the next question: Is retail participation in equity something to worry about? If the turnover in equity futures and options is considered, around 45 per cent originates from clients. Of this, companies and partnerships account for 15-20 per cent, leaving about 25 per cent for individuals.

Now, it is not possible to classify all individuals trading in derivatives as small or retail investors. Data from the NSE show that around 50 per cent of individual investors trading in derivatives transacted more than ₹10 lakh worth of shares in the cash segment in a year. Twenty-three per cent of these individuals traded more than ₹1 crore in cash market, while 8.5 per cent traded more than ₹50 lakh. Only one-third of individual investors transacted less than ₹10 lakh.

The moot question is whether individual investors who are well informed and can find their way to riches through stock derivatives should be barred just because they do not meet the net worth criteria?

The way out

A balance needs to be struck between allowing retail investors the freedom to trade derivatives while protecting them. Globally, many exchanges follow product-suitability frameworks for allowing retail investors to trade in derivatives. These are based on their minimum income or net worth, education, experience in trading and level of due diligence by stock brokers.

SEBI has currently prescribed exposure of individuals based on the disclosed income as per the ITR over a period of time. Any exposure beyond the computed limit can be allowed by the intermediary after rigorous checks.

Using the income criteria alone to allow investors into derivatives does not seem right as many of them might have been dealing in the securities market for many years. Working out a limit based on education, income and experience may be a better idea. Also, while brokers are required to do due diligence and explain the risks to investors, often, this is a mere formality, with clients signing on the dotted line without reading the fine-print. Intermediaries need to be sensitised to carry out their duties better.

Finally, addressing the anomalies in the cash market and removing the regulatory arbitrage between equity cash and equity derivatives can help reduce the turnover differential between the cash and the derivative market.

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