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Derivatives Trading in India

The case discusses the introduction and growth of the derivatives market in India.

It describes in detail the reasons that led to the introduction of derivatives trading inIndia and why it faced opposition by a section of industry analysts and media. The

case then describes the issues that still remain to be addressed by the regulatory

authorities to accelerate the long-term growth of the derivatives market.

Finally, the case mentions a few steps taken by the concerned authorities in early

2004.

Issues:

Main objectives and reasons for the introduction of derivatives trading in India

The factors that can accelerate/suppress the growth of the derivatives market in a

countryThe introduction of derivatives trading will separate leveraged positions from the spot

markets and make it easier for exchanges to implement rolling settlement. This shouldreduce volatility in the existing markets, and make risk containment and regulation easier

by making markets safer."1

- Ashish Kumar Chauhan, Vice-President, National Stock Exchange (NSE).

"It had to start at one point of time or the other. Just like a plant needs soil, water and

minerals to nurture well, for derivatives you need a healthy cash market in place."2

- Alok Churiwala, Member of Bombay Stock Exchange (BSE).

Introduction

On June 9, 2000, the Bombay Stock Exchange (BSE) introduced India's first derivative

instrument - the BSE-30(Sensex) index futures. It was introduced with three month

trading cycle - the near month (one), the next month (two) and the far month (three).The National Stock Exchange (NSE) followed a few days later, by launching the

S&P CNX Nifty3index futures on June 12, 2000. The plan to introduce derivatives

in India was initially mooted by the National Stock Exchange (NSE) in 1995. Themain purpose of this plan was to encourage greater participation of foreign

institutional investors (FIIs) in the Indian stock exchanges. Their involvement had

been very low due to the absence of derivatives for hedging risk. However, there wasno consensus of opinion on the issue among industry analysts and the media. Thepros and cons of introducing derivatives trading were debated intensely. The lack of

transparency and inadequate infrastructure of the Indian stock markets were cited as

reasons to avoid derivatives trading.Derivatives were also considered risky for retail investors because of their poor

knowledge about their operation. In spite of the opposition, the path for derivatives

trading was cleared with the introduction of Securities Laws (Amendment) Bill in

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Parliament in 1998.

The introduction of derivatives was delayed for some more time as the infrastructure

for it had to be set up. Derivatives trading required a computer-based trading system,a depository4 and a clearing house5 facility. In addition, problems such as low

market capitalization of the Indian stock markets, the small number of institutional

players and the absence of a regulatory framework caused further delays. Derivativestrading eventually started in June 2000. The introduction of derivatives was well

received by stock market players. Trading in derivatives gained substantial

popularity, and soon the turnover of the NSE and BSE derivatives markets exceededthe turnover of the NSE and BSE cash markets...

or instance, in the month of January 2004, the value of the NSE and BSE derivatives

markets was Rs.3278.5 billion (bn) whereas the value of the NSE and BSE cash markets

was only Rs.1998.89 bn. (Refer Exhibit I and II). In spite of these encouragingdevelopments, industry analysts felt that the derivatives market had not yet realized its

full potential. Analysts pointed out that the equity derivative markets on the BSE and

NSE had been limited to only four products - index futures, index options and individual

stock futures and options which were limited to certain select stocks...Background Note

The initial steps to launch derivatives were taken in 1995 with the introduction of the

Securities Laws (Amendment) Ordinance, 1995 that withdrew the prohibition on

trading in options on securities in the Indian stock market.

In November 1996, a 24-member committee was set up by the Securities Exchange

Board of India (SEBI)6 under the chairmanship of LC Gupta to develop an

appropriate regulatory framework for derivatives trading.

The committee recommended that the regulatory framework applicable to the tradingof securities would also govern the trading of derivatives.Following the committee's recommendations, the Securities Contract Regulation Act

(SCRA) was amended in 1999 to include derivatives within the scope of securities, and a

regulatory framework for administering derivatives trading was laid out.The act granted legality to exchange-traded derivatives, but not OTC (over the

counter) derivatives. It allowed derivatives trading either on a separate and

independent derivatives exchange or on a separate segment of an existing stockexchange. The derivatives exchange had to function as a self-regulatory organization

(SRO) and SEBI acted as its regulator.

The responsibility of clearing and settlement of all trades on the exchange was givento the clearing house which was to be governed independently. Derivatives were

introduced in a phased manner. Initially, trading was restricted to index futures

contracts based on the S&P CNX Nifty Index and BSE-30 (Sensex) Index...Those who opposed the introduction of derivatives argued that these instruments would

significantly increase speculation in the market.

They said that derivatives could be used for speculation by investors by taking largeprice positions in the stock market while committing only a small amount of capital

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as margin.

For instance, instead of an investor buying stocks worth Rs.1 million (mn), he couldbuy futures contracts on Rs.1 mn of stocks by investing a few thousand rupees as

margin. Thus, trading in derivatives encouraged investors to speculate - taking on

more risk while putting forward less investment. They were quick to point out someof the disasters of the past that had occurred due to the mismanagement of trading in

derivatives (Refer Exhibit III)...

A Few Issues Remain

By January 2004, more than three and a half years of derivatives trading had been

completed. However, according to several analysts and media reports, SEBI, NSE andBSE had still to resolve many issues so that the derivatives market could realize its full

potential.

For instance, the issue of imposing taxes on income arising from derivatives trading

still remained to be sorted out. The Income Tax Act of India did not have any

specific provision regarding taxability of derivatives income. The tax authoritieswere still undecided on the issue, and in the absence of any provision, derivatives

transactions were held on par with transactions of a speculative nature (in particular,the index futures/options which were essentially cash settled, were treated this way).

Therefore, the loss, if any, arising from derivatives transactions, was treated as a

speculative loss and was eligible to be set off only against speculative income upto amaximum period of eight years...

As of early 2004, derivatives trading in India had been restricted to a limited range of

products including index futures, index options and individual stock futures and options

limited to certain select stocks.Analysts felt that index futures/options could be extended to other popular indices such

as the CNX Nifty Junior . Similarly, stock futures/options could be extended to allactive securities. Efforts were also on to encourage participation from domesticinstitutional investors. SEBI had authorized mutual funds to trade in derivatives,

subject to appropriate disclosures. A broader product rollout for institutional investors

was also on the cards. Steps were taken to strengthen the financial infrastructure. Theseincluded developing adequate trading mechanisms and systems, and establishing

proper clearing and settlement procedures. Regulations hampering the growth of

derivative markets were being reviewed...