Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Daily Archives: July 31, 2017

Equity Derivatives versus Cash Equities in India

The Securities and Exchange Board of India (SEBI), the Indian securities regulator, put out a discussion paper a couple of weeks ago on the Growth and Development of Equity Derivatives Market in India. The Indian Equity Derivatives Market is one of the success stories of financial market development in India and clearly, it makes sense to study this market to draw lessons that could help replicate this success in other segments (bond markets for example) that have remained under developed after 25 years of reforms.

Unfortunately, the SEBI discussion paper seems to prefer levelling down to levelling up. Rather than bring other markets up to the high standards set by the equity derivatives markets, it seeks to clamp down on this successful market to reduce it to the mediocrity of other lacklustre markets.

The discussion paper is worried about the high ratio of derivative market turnover to cash market turnover, and thinks that therefore there must be something wrong with the derivative market. The correct conclusion is quite the opposite: there is something grievously wrong about the cash market. Several policy makers have conspired to prevent a vibrant cash market from emerging in India:

  1. The Reserve Bank of India (RBI) places severe restrictions on capital market related lending and therefore starves the cash market of credit. Everybody who seeks leverage is therefore forced to move to the derivative market. SEBI has a margin trading scheme, but this scheme has been largely a failure.

  2. For a different set of reasons, the securities lending scheme has also failed to take off, and those desirous of taking a short position in stocks are also forced to turn to the derivative market.

  3. The government in its greed for tax revenue (with near zero collection cost) has pushed up the securities transaction tax to punitive levels in the cash market. Though the difference in price elasticity in the two markets could make the revenue maximizing rate of taxation unequal in the two markets, it is likely that the current rates are not actually optimal even from a revenue maximizing point. More importantly, the rate of transaction tax in the cash market is far too high from a social welfare point of view.

These factors have stunted the growth of the cash equities market in India. The liquid derivatives market has ameliorated this problem for the top 50-100 companies. But that leaves hundreds of other companies in the lurch. In my view, this is a serious problem because a vibrant equity market is important for economic growth. All policy makers (SEBI, RBI and the Finance Ministry) need to come together to fix the flaws in the cash equities market.

I believe that India can create a reasonably liquid market for the top 1000 companies in the country. Market participants laugh at me when I say this, but if the US can do this, I do not see why India cannot. We have all the institutional prerequisites for such a market – world class depositories, exchanges, and clearing corporations; a large ecosystem of intermediaries; a strong regulator; and above all a vast investor base. I hope that regulators will raise their sights and aim for this, rather than try to cripple the derivative market so that it is no longer obvious that the cash market is limping.