Short on delivery

The stock market regulator is quite right in feeling concerned about the heightened speculative activity in the equity derivative segment. Volumes have been soaring in derivatives, even as the cash segment has been growing at a much slower pace. The skew in the turnover due to this uneven pace of growth was highlighted by the SEBI discussion paper on growth and development of equity derivative market released last July. The report had highlighted that the ratio of turnover of equity derivatives trades to cash trades had increased from 1.54 to 15.59 between 2004-05 and 2016-17. However, the regulator has not done anything to address this issue in its recent board meeting. The changes announced in the meeting relate to stock derivatives segment that account for only 20 per cent of the derivative turnover. The index derivative segment that accounts for 80 per cent of equity derivatives has not been on the regulator’s radar, this time.

The changes proposed to stock derivatives also appear inadequate. While the finer details are awaited, the rules put out on Wednesday suggest that stock derivatives of large-cap stocks with higher trading interest will continue to be cash settled. The regulator has revised the criteria for selecting stocks that trade in the derivative segment, proposing higher limits for open positions in derivative and cash segments and larger order sizes. Only those stocks that do not meet the enhanced criteria, are to be physically settled. If trading volume does not improve, in the physically settled stock, within a given time-limit, the stock is to be weeded out of derivative segment altogether. This move appears to be aimed at ensuring that only the more liquid stocks trade in the derivative segment since the thinly traded stocks are more vulnerable to price manipulation. While the regulator has said that physical delivery will be introduced in a phased manner, it would have been better if physical delivery had been mandated in the stock derivatives with higher trading volume. This would have helped improve liquidity in cash segment and established a link between the cash and derivative segment. The stock lending and borrowing mechanism could also have improved if physical settlement was mandated in the popular stocks. By mandating this mode of settlement in the less-traded stocks, traders are being given the choice to avoid these stocks altogether.

That said, the move to ensure ‘product suitability’ among investors in equity market needs to be lauded. The lure of higher returns is attracting smaller investors into equity derivatives, with such investors currently accounting for 26 per cent of these volumes. The proposal to limit the exposure of investors to both cash and derivatives segment based on the income, as disclosed in the income tax returns, will protect smaller investors. Implementation of these rules will however be tricky, and could result in temporary decline in trading volume in the market. There will also be higher compliance burden and additional cost for intermediaries.

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