September 2003

Imperfect new index derivatives

Reintroducing borrowing and lending of shares and moneys

top                     Imperfect new index derivatives

September 2003

Taking advantage of the runaway prices in the market, the National Stock Exchange has launched futures and options trading on its information technology sector index, 20-stock CNX IT. This will be the second index after its main index, 50-stock S&P CNX Nifty, on which futures and options trading will take place on the NSE.

NSE's move seemingly stems from the market's continued obsession with IT stocks. This is further hinted by the fact that NSE also has a second mainline index, 50-stock CNX Nifty Junior, on which it has not chosen to introduce derivatives trading yet. Derivatives on the CNX IT index move may not serve investors' interests well because of the design of the index.

Imperfect index design. Of the two components of criteria for inclusion in an index—market capitalisation and liquidity—the CNX IT index falters on the latter. Unlike S&P CNX Nifty and Nifty Junior which uses impact cost calculations for determining liquidity of stocks for including them in the index, the CNX IT index uses only trading volumes and trading frequency as the liquidity determinant.

There is also a lack of disclosure about the index selection criteria. NSE just limits itself to saying on the indices section of its website that "a company’s rank based on the average market capitalisation over a six month period is an important consideration for its selection in the CNX IT Index." Similarly for the other criteria of trading volumes it just states "the companies considered for inclusion must rank among the highest in the IT sector in terms of annual trading turnover and must have demonstrated a high level of trading frequency in the previous six month period."

This is again unlike in the case of Nifty and Nifty Junior where the criteria is clearly laid down. For a stock to go in Nifty it should have a minimum market capitalisation of Rs 500 crore and it should be getting traded at an impact cost of less than 1.5 per cent (the corresponding figures for Nifty Junior are Rs 200 crore and 2.5 per cent).

The index is also heavily skewed in its weightages. Among the existing 20 stocks in CNX IT index, about 72 per cent weightage in the index is taken up by three IT heavyweights—Infosys Technologies, Wipro and Satyam Computer—itself.

Contract specifications. The futures and options contracts on CNX IT index will be in a minimum lot of 20 and multiples of 20 thereafter. The index value at the time of introduction of the derivatives contracts on it on August 29 was hovering around 15060 which means the minimum contract exposure that you will have to take would be a little over Rs 3,00,000. This meets the minimum Sebi-imposed condition of Rs 2 lakh for any derivatives contract size at the time of introduction.

Like other index and stock derivatives, the CNX IT futures and options too will have a maximum of near-three month contracts each expiring on the last Thursday of the respective month.

At best, investors could use NSE's new IT index derivatives to hedge the technology sector exposure of their portfolios but with the clear understanding of the limitations of the index design and the consequent distortions it may produce while tracking the technology sector.

top       Reintroducing borrowing and lending of shares and moneys

September 2003

Financing for purchases, popularly known as 'badla finance' in earlier times, and securities borrowing and lending scheme were banned by the Securities and Exchange Board in the immediate aftermath of the detection of Ketan Parekh-induced securities scam in March 2001.

But the underlying principles of the two products are now sought to be re-introduced by a Sebi-constituted big 15-member secondary market advisory committee. This standing committee which was reconstituted by Sebi in May 2002 and met nine times thereafter submitted a report to Sebi on August 19 outlining its recommendations on the specific issues of margin trading, securities lending and short sales.

Margin trading. Margin trading enables speculators to buy shares without having the full money to fund it. Till mid-2001 this exact thing was possible under BSE's 'badla' finance mechanism and NSE's automated lending and borrowing mechanism before they were banned by Sebi as a reaction to the post-budget fall in share prices.

The market had moved to rolling settlements in July 2001 and a new margin trading mechanism was introduced in November 2001. The Reserve Bank of India permitted banks to finance stock market trades upto 60 per cent of the trade value, the balance 40 per cent being the margin. The Sebi committee now wants the margin to be relaxed to 20 per cent and RBI-licensed non-banking finance companies (NBFCs) to be allowed to carry out such margin trading activity.

In addition the committee wants Sebi to change its legislations such that brokers are allowed to finance their clients' trades. Presently, brokers are not allowed by law to conduct fund-based activity. The committee's recommendation states brokers can finance his clients purchases either from his own funds or through borrowings from only banks and NBFCs and at a minimum margin of 40 per cent.

From market safety perspective these recommendations may not be desirable in the suggested structure. Earlier, in badla and ALBM, all individuals could participate in financing and that acted as a market-wide check on the rates. If the participation is restricted to only banks, NBFCs and brokers then there could be unhealthy cartelisation.

Stock lending.  The committee has suggested that shares can be lend and borrowed through a common pool of securities from which the clearing corporation would borrow shares on behalf of the broker and his client that has not delivered shares. This would be akin to the former ALBM except that there would be no intermingling of obligations (to return borrowed shares) with the cash market trade obligations and the clearing corporation would have to independently arrange for the shares to be bought separately from the market and returned to the lender. The other difference is that the committee again wants only institutional investors to be allowed to lend shares whereas in ALBM individual investors could also lend shares.

What it means to you.  If you want leverage to buy or sell shares then take it from the derivatives segment of the market. Borrowing funds or shares to buy or sell shares on the cash market, through the market structure as suggested by Sebi, is likely to be fraught with high interest costs and inadequate safety.

Individual investors have been kept out of the participation loop. So you won't be able to lend funds or shares through the reintroduction of financing for long purchases and lending for short sales in the form of margin trading and stock lending. It is an unfortunate exclusion.

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