How to reduce the high derivatives turnover in India?

Over the past few years, SEBI has been trying to curtail turnover in the derivatives segment through various regulatory actions. In July 2015, SEBI mandated the increase in the minimum derivatives contract size from Rs 2 lakh to Rs 5 lakh. Derivatives contract lot sizes were revised upwards accordingly. This was a move to make it expensive (in terms of margins) for small retail investors to participate in the derivatives segment. More recently, SEBI has approved the introduction of compulsory delivery for derivatives on stocks. The exchanges have introduced this for some stocks and it will be increased over time to cover more stocks. Compulsory delivery has been introduced to align the cash and derivatives segment and hopefully drive down turnover in the derivatives segment because it is more expensive to settle a contract through delivery rather than cash settlement. But will these steps have the intended consequences? The answer is most likely no.

To understand this, it is important to look at some recent data. India, by far, has the highest notional derivatives turnover to cash turnover ratio. Year-to-date (January to June 2018) numbers from the World Federation of Exchanges Web site show this ratio to be 23. The next highest is the Korea Exchange at 17. This ratio is in single digits for all other markets, with the next two highest also being Asian markets, Hong Kong at 7 and Taiwan at 6. A closer look at the Indian data shows that this ratio is 1, 2, 19 and 1 for the single stock options, single stock futures, index options and index futures, respectively. Globally, the ratio for single stock options and futures are high but not for index futures. The single biggest reason for the high overall ratio in India is the index options segment. The question is if the steps taken by SEBI will reduce index options turnover.

Compulsory delivery is aimed only at single stock derivatives and not index derivatives. Given that an index is a portfolio of stocks, it is prohibitively expensive to mandate compulsory delivery for index derivatives. Increasing the minimum derivatives contract size is also unlikely to impact index options turnovers because it is likely that institutional investors are the ones driving this high turnover. The margin on a contract with a value of Rs 5 lakh is likely to be around Rs 75,000, which is not a large amount for institutions. Further, compulsory delivery is unlikely to impact turnovers of single stock derivatives. All of this means that investors will not hold their positions until expiration. They will square it off before expiration. In fact, given this, we will most likely see increased volatility and turnover just before contract expiration, which is the opposite of the intended consequence of these regulatory changes.

At the same time as introducing compulsory delivery, SEBI also increased the thresholds of various liquidity measures that companies trading in the derivatives segment must meet to continue to be allowed to trade in that segment. As a result, it is expected that a large number of stocks would exit the derivatives segment in the near term. This will likely drive down turnovers for single stock derivatives but will not impact index derivatives.

What are the likely reasons for high derivatives turnover? Tax and regulatory arbitrage is one. The securities transaction taxes (STT) for transactions in the derivatives segment is lower than in the cash segment. In the cash segment, an STT of 0.025% is imposed on non-delivery-based transactions while it is 0.10% on delivery-based transactions. In the derivatives segment, it is 0.05% for options and 0.01% for futures. An investor who plans to hold a position for at least one day would prefer trading in the derivatives segment rather than in cash segment. For non-delivery (intraday) positions, futures are cheaper than cash. This difference in the STT across segments makes the derivatives segment a lower cost alternative to the cash segment. If an investor wants to make a directional bet on an index, they would prefer index derivatives rather than exchange-traded funds (ETFs) on the index because of this STT differential. ETFs trade in the cash segment and are taxed as such. Given that options protect the downside whereas futures do not, investors would prefer trading index options to index futures.

While SEBI does not have the power to change the STT, the government of India should take cognizance of this tax arbitrage and eliminate the STT differential across market segments. Reports suggest that SEBI has approached the government about this earlier this year and hopefully it delivers on this request. The elimination of this STT differential is best achieved by decreasing STT for the cash segment rather than increasing it for the derivatives segment. Studies of the impact of STT on security markets by various researchers have consistently shown that market liquidity and efficiency, both measures of market quality, worsen when STT is introduced. Increasing STT is likely to have the same adverse consequences on these measures of market quality. In fact, the ideal scenario would be for the government to completely eliminate STT. This would improve various measures of market quality in addition to eliminating the abnormally high turnover of derivatives relatively to the cash segment.

The other reason for the high volumes is that institutions (both domestic like mutual funds, insurance, etc. as well as foreign) are not permitted to short sell in the cash segment, whereas, they can take short positions in the derivatives segment. Short selling is investors’ ability to sell shares or other securities that they do not own. This is done by borrowing these securities and selling them with a promise of replacing the borrowed securities at an agreed upon future date. If investors have negative information about a security, especially, one that they do not own, they will short sell the security now and buy it back at a later date when its price has, hopefully, decreased. However, since institutional investors cannot short sell in India, if they have negative information, they have to take short positions in the derivatives segment, which drives up the turnover in that segment. A solution to this problem is to allow institutional investors to short sell in the cash segment. However, they should not be prevented from taking short positions in the derivatives segment. That is definitely not a solution. Arbitrageurs, a role largely played by institutional investors, keep prices in the cash and derivatives segment correct relative to each other. Preventing institutional investors from taking short positions or even participating in the derivatives segment would make prices in both segments extremely inefficient and would essentially destroy them. Permitting institutions to short sell in the cash segment would also have the added advantage of providing impetus to the securities lending and borrowing (SLB) segment, which has been languishing with insignificant volumes since its introduction in 2008. The SLB segment provides a formal platform for investors to be able to borrow shares that they wish to short sell.

In the context of index derivatives, if institutional investors have negative information about an index or want to hedge the risk of the index (portfolio insurance), they would have to short sell an ETF on the index, which they are not permitted to do. However, they can take short positions in index derivatives to achieve either or both objectives, which again shows why index derivative turnovers end up being very high.

To conclude, if high derivatives turnover is a matter of concern, it is best addressed by completly eliminating the STT differential between the cash and derivatives segments and permitting institution investors to short sell in the cash segment.

Ramabhadran S. Thirumalai is the Clinical Assistant Professor of Finance at the Indian School of Business (ISB).