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Is the derivatives market model a weak link?

Deena Mehta

Share futures are most successful in India than anywhere else in the world because they are seen as a substitute for badla. The new system has to be better than the old one and not add to risk in the market.

THE CURRENT rise of the Bombay Stock Exchange Sensitive Index (Sensex) is largely credited to a robust economy, FII (foreign institutional investment) flows and the large liquidity in the system on the back of reduced interest rates and the absence of more profitable avenues of investment. A less talked about reason that needs equal consideration is the structure of the derivatives market and the absence of physical deliveries.

The L. C. Gupta Committee — the starting point and guiding beacon for the derivatives market in India — advocated that stock futures should be introduced only after a system for lending and borrowing of shares is in place. It, therefore, visualised physical exchange of shares for settling the trades executed in the futures market for individual stock futures. Instead of introducing the lending and borrowing system, a short-cut was adopted and cash settlement insisted upon even for individual stock futures.

The erstwhile Committee on Secondary Market believed that introducing a share lending and borrowing mechanism would amount to badla. It, therefore, advocated that if stock futures are introduced, they should be cash settled; no lending and borrowing mechanism was thought necessary in such a model. All suggestions for making the Margin Trading System workable were rejected as also ideas of lending and borrowing. The Committee put up its report twice on its Web site, but did not accept any feedback from the market participants.

Now let try and understand the connection between the current boom and the impact of cash settlement in the derivatives market. Physical settlement is a logical conclusion of the transactions done on the exchange. Physical settlement implies that at the end of the contract period the investor's position would lead to either giving or taking delivery. For purchases, the investor would get delivery and vice versa. A lending and borrowing system is required for investors who have gone short and would like to cover the position later on and hence would want to borrow stock. Margin trading is needed for investors who require leveraging facility to take delivery.

One class of investors would like to square the position before the closing date and would hence do a reverse trade in the market. Thus, every buy position results in a counter sale and vice versa. Every investor who has short sold would have to go to the cash market and buy and give delivery, or buy in the futures before the closing date.

In the absence of physical delivery, the system simply flushes out all trades at the end of the month when the contract expires. There is no logical conclusion to the futures trade. On the last day, cash is exchanged and the one-way traffic of buy does not have any speed-breaker of sale transactions. The continuous balancing of buy and sell does not happen and the populist view gets further propagated as the buyer does not have any obligation to take delivery.

He can pay a nominal margin and be rid of any further obligation to complete the trade. Similarly, in a bear market the investor simply sells and then the trade is swept off the outstanding book. Experts argue that as the deliveries in the derivatives markets are only in the 2- 5 per cent range, why have them at all. It must be understood that this is resultant delivery after the open positions have been squared, hence 98 per cent were counter trades. If we do not provide for these counter trades then there will be no balancing factor in the market. For those who want to manipulate the market it is easy to maintain the last day prices so that the square off rates are high/low as desired. If all trades have to logically close, then such manipulations have no place in the market.

A reverse trend in the market would follow the same path of one-way fall and the market would just technically keep going down without any reason. Share futures are most successful in India than anywhere else in the world because they are seen as a substitute for badla.

The new system has to be better than the old one and not add to risk in the market. The current futures market without deliveries is more of a speculative avenue rather than fulfilling the need of hedging. The fact that futures prices are at a discount shows that the underlying cash and the futures markets are not in sync and operate in their own orbits. It is well known that the derivatives market has been used to heavily short sell when the going was not good in banking and PSU stocks.

The country takes great pride in following international best practices. In all developed countries, derivative trades are delivery settled. The danger of a cash settled system is highlighted above. After the experience of five years in the derivatives market, the regulator must look at the issue on hand objectively. The size of derivatives market being bigger than the cash market, we cannot afford a structurally weak system.

(The author, a former President of the Bombay Stock Exchange, is Managing Director of Asit C. Mehta Investment Intermediates Ltd. Contact: damehta@acm.co.in)

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