Since February 2008, the share of trading in index options, predominantly options on S&P CNX Nifty 50 index (Nifty), has risen about four times. Interestingly, this has come about at the cost of the Indian speculator’s favourite: futures in individual stocks, where the traded value has more than halved (see ‘Emerging Trend’).
The downward movement in stock futures has shifted traders’ attention to options contracts, which are less risky than naked futures if one is buying a put or a call option. “Since a year when equity markets have been on a slide, traders have found that it is difficult to gauge the market movement, and find themselves quickly out of the game,” says Gurudatta Dhanokar, head strategist of derivatives at Almondz Global Securities. “So, they have preferred to dabble in buying options, particularly index options, where they know their maximum losses upfront.”
In options trading, the price paid is the market-determined premium. If one buys a call option on Nifty that has a strike price of 2,500, one pays just the premium amount (say 25). If the Nifty goes down by over 25 points the call option buyer’s loss will still be restricted to the 25 premium as he cannot exercise his loss-making option on expiry.
Index options contracts are also the most active equity derivatives contracts the world over. Eurex, Euronext Liffe, Korea Exchange, Australian ASX Derivatives Exchange, Hong Kong Exchanges, Borsa Italiana and Brazilian Bovespa are among the largest equity derivatives exchanges. Their combined notional turnover in 2008 (till November), according to the World Federation of Exchanges, in index options was the highest at $42.9 trillion, followed by that in index futures at $13 trillion, in stock options at $3.4 trillion and in stock futures at $1.1 trillion.
Time To Move Forward
With Nifty options and futures turnover overtaking that of stocks derivatives, NSE should seriously think of aligning with world trends to keep the growth momentum going. NSE faces tough competition from Singapore Exchange (SGX) in Nifty futures (see ‘Early Bird’, BW, 5 January 2009). “Because of the October 2007 restrictions on foreign investors’ participation through structured products on onshore Nifty futures and options, the market has moved to Singapore’s dollar-denominated Nifty futures,” says Vipul Dalal, country head of Mumbai-based Elara Securities, a subsidiary of London-based Elara Capital. Dalal points out that the turnover in SGX’s Nifty futures contracts has grown multiple times in the past 17 months and is near to overtaking the onshore Nifty futures turnover.
BW learns from sources that NSE is ready to compete with SGX if given a level-playing field in terms of product design and removing restrictions on foreign participation. “Big banks and hedge funds build synthetic hedges around the US dollar-denominated SGX-listed Nifty futures and that business can come into India if regulations allow it,” says Dalal. This can happen if Sebi moves fast on giving approvals to NSE’s proposals.
Tapping OTC Market
The demand for structured products demand also connects to trading volumes taking place in the wholesale market, or over-the-counter (OTC) market. Internationally, New York Mercantile Exchange (NYMEX) and NYSE Euronext Liffe are actively tapping the OTC equity derivatives market in the US and Europe, respectively. In 2004, Liffe realised that equity derivatives volumes in Europe were shifting away from the exchanges and estimated that about 80 per cent of it was happening through OTC market. In OTC market, the International Swaps and Derivatives Association had offered support to attract investment banks and funds to do derivatives OTC.
“But we saw that as an opportunity to do the exact opposite — to get them on to exchange-traded platform,” says Fraser Cowie, executive director of trans-Atlantic business development at London-headquartered Liffe division of NYSE Euronext.
In early 2005, Liffe introduced a single clearing platform, Bclear, for OTC trades in equity options spanning across 13 European markets. “Here, we don’t match trades but you book the trade and get it reported and cleared through us,” says Cowie. “The cost of processing is kept low.” Cowie believes the exchange-traded platform and OTC platform have a positive effect on liquidity on each other, because of the increased visibility of OTC trades. The trading volume in OTC equity derivatives on Liffe was €783 billion (about Rs 52,24,900 crore) during the 14 month between January 2008 to February 2009 compared to the exchange-traded turnover of €2,357 billion.
The Liffe model can be replicated in India. “Wherever humanly possible, the derivatives trades should be exchange-traded, but where OTC trades occur, they should be routed through a central clearing counterparty,” says Ajay Shah, senior fellow at the Delhi-based Institute of Public Policy and Research. “A clearing corporation will collect margins and ensure there is no mess if a Bear Stearns collapse-like scenario occurs,” says Shah.
In equities, OTC trades scenario is only felt in terms of attracting the overseas OTC trades structured around a Nifty futures or a NSE/BSE-listed stock. For it to become a reality, Sebi will have to amend the Securities and Contract Regulation Act to allow derivatives trades to take place outside the exchanges.
Minor tinkering of existing products can help. Physical settlement of stock derivatives, instead of cash-settled contracts can help arbitrageurs and hedgers. The equity derivatives market is the only financial market in the country where the trading volume counts among the top 5-10 markets in the world. But to stay there, Sebi needs to broaden its regulatory framework for market-demanded products and features.
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