Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

OTC Equity Derivatives in India

I wrote an article
in the Business Standard today arguing for the creation
of an OTC equity derivative market in India.

I made the following points

  • Competition between Over the Counter (OTC) markets and exchanges
    forces each market to lower costs and to adopt the best practices of
    the the other market.
  • Standardized and highly liquid contracts are best traded in
    organized exchanges because of the enhanced transparency and lower
    systemic risk. However new contracts are often best incubated in OTC
    markets until they achieve a critical mass of liquidity and widespread
    participation at which point they can be moved to the exchange traded
    format. Long dated equity options are today best incubated in OTC
    markets.
  • Exchanges should be allowed to introduce flexible options where
    market participants can choose parameters such as exercise prices,
    expiration date and type of expiration (American or European style)
    provided they trade the contracts in large blocks (say $10 million
    notional value). These flexible options are listed, margined and
    cleared like the standard options and therefore combine the
    flexibility of OTC options with the transparency and low systemic risk
    of exchange traded options.
  • The Participatory Note (PN) or Offshore Derivative Instruments
    (ODI) market which the Foreign Institutional Investors (FIIs) have
    created outside India is essentially an OTC market in Indian equity
    derivatives. Indian regulations have driven this important market
    outside India and the result is a loss of liquidity for Indian
    markets, a loss of income for Indian financial services firms and a
    loss of access to OTC derivative markets for Indian securities and
    investment firms.
  • To bring the PN/ODI market back to India, we need to do two
    things.

    1. The Securities Contract Regulation Act should be
      amended quickly to allow OTC equity derivatives in India. (Flexible
      options are a short term measure that avoids this statutory
      amendment).
    2. We must also establish a tax system for portfolio
      investment similar to that of the United States. The US does not tax
      “Portfolio Interest” income, capital gains on securities
      and income from derivative transactions (“Notional Principal
      Contract” income) earned by foreign investors. For too long,
      India has used the Mauritius double taxation agreement as an excuse
      for not doing something similar, but the Mauritius solution works only
      for investment in equities and not for investment through
      derivatives. The time has come to take Mauritius out of the loop
      altogether.

    I look forward to the day when a securities firm in India
    can sell an OTC derivative to a foreign hedge fund without any of the
    fee income leaking out of India to Mauritius or elsewhere.

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