Fixing the futures

An inherent weakness in the Indian stock market is that it has been over-run by speculators despite its size. Delivery-based cash trades have stagnated and the primary market has been in the doldrums, but derivative trades, with active retail participation, have grown from strength to strength, now accounting for close to 90 per cent of all market activity. The move by the Securities and Exchange Board of India (SEBI) to increase the minimum contract size in equity derivatives from ₹2 lakh to ₹5 lakh needs to be addressed in such a context, as one aimed at deterring retail investors from being singed in this risky market.

But the move has its negative aspects. A revision in the contract sizes for derivatives was overdue, given that the lot sizes were last set in 2000, but the sharpness of the recent increase is bound to take market participants by surprise. The increase is astronomical for some stocks such as Unitech and JP Associates where lot sizes have suddenly shot up five- to six-fold. This will mean that smaller investors have to fork out much higher margins while trading in derivatives. Those who cannot afford the increased payout may have no choice but to withdraw. This can have a significant adverse impact on market liquidity. Given that all trades in the stock market involve a counter-party, one simply cannot remove one section of players from the market without affecting others. Nor can one presume that all the positions taken by retail investors in derivatives are speculative; derivatives are an effective hedging tool as well. NSE data show that retail investors today account for a sizeable 40 per cent of the total open interest positions in the Futures and Options (F&O) segment as against foreign institutional investors’ 36 per cent. This suggests that not all retail investors in the F&O segment are there for the ultra-short term. A good number roll over their positions from month to month.

There are other ways to protect retail investors. One option is to promote delivery-based trades in derivatives, as opposed to cash-settled contracts; but then again, making delivery compulsory may dent volumes. SEBI also can tighten the eligibility criteria for stocks that trade in F&O, so that only quality companies gain an entry. A uniform lot size for all contracts at either 50 or 100 may allow investors to choose contracts based on their capital availability. Currently, cash market trades attract a higher incidence of securities transaction tax (STT) than derivative trades, so levelling the playing field by reducing STT, which is in the Centre’s domain, may help too. Above all, the market regulator, along with intermediaries, should focus on educating investors about the risks of derivatives trading. Eliminating or heavily suppressing one segment of the market could do more harm than good to market health in the long term.

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