October 2003

Run-away derivatives?

Regulators keep silent while markets boom

top                            Run-away derivatives?

Trading activity in derivatives has skyrocketed overtaking that in the cash market. But whats unique is its composition.

October 2003

Not only have equity derivatives traded quantity and value in our stock market doubled in last three months and quadrupled in six, it has overtaken the trading volumes in the cash market (where you buy and sell shares to get ownership rights in a company) and continues to increase that gap (see graph1, table1). Such amazing growth rates are rarely seen in international securities markets.

Looking at current record trading volumes in equity derivatives of almost Rs 10,000 crore every day one might get the impression that equity investors find their equity investments so full of risk that they are rushing to the derivatives market to hedge themselves and finding enough risk-taking traders.

"It was expected", says Ashok Jogani, director, ASK Financial Services, active NSE derivatives-cum-cash market member. "The market needed a leverage product and got it." Also, Jogani feels, price discovery first happens in futures trading and the spot (cash) market catches up a bit later.

Equity derivatives presently comprise of index futures, index options, stock futures and stock options. Index futures kicked off in June 2000, index options in June 2001, stock options in July 2001 and stock futures in November 2001. Almost all derivatives trading is concentrated on the National Stock Exchange (the Bombay Stock Exchange registers nominal trading activity).

On the NSE, the trading is concentrated in futures trading on the 53 permitted stocks. This currently accounts for 65 per cent of all equity derivatives trading. Nifty futures currently takes up 23 per cent, stock options 11 per cent and Nifty options just two per cent (see graph2, table2).

The fact that two-thirds of derivatives trading is in individual stocks is unique in the world. In almost all international equity derivatives markets the bulk of the trading is in index futures and index options.

Consider the 45-year old Sydney Futures Exchange (SFE) in Australia which started off with wool futures. Among other commodity and financial derivatives products it added later were included equity derivatives products—index futures in 1983, index options in 1985 and stock futures in 1994 (no stock options has been added uptil now).

A look at its September 2003 trading data reveals index futures recording a trading volume of about 5,85,000 contracts, index options with 67,000 and stock futures 2,700. Of the total of these three, stock futures contributes a meager 0.5 per cent, index options 10.2 per cent and index futures 89.3 per cent. This has been the general historical trend at SFE. Stock futures have been around at SFE for 10 years now.

In the United States where the commodity and financial derivatives exchanges at Chicago are the oldest stock futures trading commenced as recently as November 2002 when three veteran derivatives exchanges—Chicago Mercantile Exchange, Chicago Board of Trade and Chicago Board Options Exchange—came together in a joint venture and floated a new futures exchange, OneChicago, specifically for futures trading on individual stocks. A year after, the trading in stock futures at OneChicago comprise less than one per cent of those in index futures and index options on its parent exchanges.

One explanation for the focus on stock derivatives trading in our market could be the historical propensity of traders to carry out their speculation trading activity in individual stocks. Says Jogani "traders here are savvy enough to take the riskier trading positions on individual stocks; they are not comfortable with trading on the index." Or, as Deepak Chhabria, head-equities at NSE derivatives-cum-cash member Birla Sun Life Securities, says "The derivatives market is more sophisticated here."

But looking at the history of scams in the Indian markets one can not fail to notice that price manipulation and insider trading occur with unnerving regularity in individual stocks. That's where the opportunities—legal and illegal—for making hordes of money lies for speculators, operators and company promoters.

Derivatives are generally understood to serve the purpose of managing financial price risk. They allow risk-averse market participants to transfer risk to other market players taking a 'high risk high return' strategy. In the Indian context, the trading activity suggests that less of risk-transfer from equity investors to speculator risk-takers is happening and more of risk-exchange is happening between speculators and wannabe manipulators.

top                 Regulators keep silent while markets boom

It can not be said with certainty that the current market flare up is not being driven by price manipulation.

October 2003 

Consider this: in a near five month period this year from 9 May to 3 October the 50-stock S&P CNX Nifty index of the National Stock Exchange has sky rocketed by 54 per cent from 937 to 1449. Now when was the last time Nifty rose this much (more than a half) in such a short span of time? You got it. It was during the Ketan Parekh scam-driven boom of 1999-2000 when Nifty had shot up by 57 per cent in around five months from 931 on 26 April 1999 to 1469 on 7 October 1999.

This kind of spurt is just in the mainline index stocks. In other actively traded stocks the price spurts are phenomenonal ranging from 100 per cent to 500 per cent. This was the case during 1999 and is the case currently during the past six months. The boom of 1999-2000 culminated in a doom in 2001 primarily because on account of price manipulation by operators such as Ketan Parekh. Is the same happening now?

The leverage that was then available to market players was in the form of carry forward trading (through badla on the Bombay Stock Exchange and automated lending and borrowing mechanism on the NSE) in a weekly settlement system. Operators got leverage also by shifting their positions from one exchange to another due to different settlement cycles. At present, the market is on rolling settlements and the leverage is available through derivative products, primarily stock futures.

The NSE and BSE run their online price surveillance system under which they are supposed to be alert for potential price manipulation cases after analysing real-time price movement trends and corresponding trading volume trends. After suspecting price manipulation in a stock, the two exchanges are supposed to investigate the records of their brokers through whom the suspected-manipulation trades are taking place.

But is this happening? Outlook Money asked the two stock exchanges. The BSE did not respond and NSE's vice president Joseph Bosco said that NSE has taken certain measures to ensure smooth settlements and these include revision in the differential exposure multiple for some stocks from five times to 8.5 times (through its circular to brokers dated 21 July), scaling up value-at-risk margins of certain stocks (through another circular dated 21 July) and imposition of additional 10 per cent margins on certain stocks (as per circular dated 3 September).

The NSE, however, did not specify whether in addition to margins and exposure revisions it has commenced any detailed investigation of the trades in any stocks that showed flared-up price rises and volumes.

The stock exchanges, however, do not have the regulatory jurisdiction to go beyond brokers' records and investigate brokers' clients' records and motives. This is where the source of the funds coming in the market can be checked. Only the Securities and Exchange Board of India has such a regulatory jurisdiction. Is Sebi conducting any detailed investigations of such kind? Queries sent to Sebi chairman G.N. Bajpai, Sebi full-time director member T.M. Nagarajan and Sebi executive director (secondary market) Pratip Kar evinced no response.

Given the lack of transparency in Sebi, NSE and BSE with regard to sharing detailed information on steps being taken to stop a scam from occurring, investors need to be doubly careful while investing and not get carried away by the market boom.

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