FUTURE OF FINANCIAL DERIVATIVES IN INDIA: PRAKHAR HARIT

INTRODUCTION

On Jan. 2020, the news about National Stock Exchange made its way to the finance section of newspapers which read as “NSE turns world’s largest exchange in derivatives trading”[1]. It highlighted the achievement of NSE which became the world’s largest derivatives exchange marketplacein terms of trading volumes, thereby replacing the US-based CME group. It was certainly a piece of very good news especially when Covid-19 fears had started shadowing over the securities exchanges all over the world. But an obvious question arises about what this meant to Indian Securities markets and what will be its future, especially after the pandemic?

WHAT ARE DERIVATIVES?

Before we dive into the pith and substance of derivatives, let us first try to understand what a derivative is. In formal terms, Derivative is a product whose price is derived from other variable called ‘bases’ which can either be an underlying asset like equity, forex, commodity, etc., or index or reference rate[2]. For ex., when we talk about flour, we know that it's derived from wheat and if there is any price fluctuation in wheat, it shall certainly affect the prices of flour. Here flour is derivative of wheat.Suppose a farmerwishes to sell his wheat on a later date but to eliminate any risk of changing prices, he enters a contract with the shop owner to sell his produce at a fixed price which shall be the price at the time of contract. Such a transaction is called ‘Derivative’ and the process of deriving ‘spot price’ is called ‘underlying.

From the above example, it can be concluded that Derivative refers to a broad class of instruments which derive its value from the price and other related variables of an underlying asset. It is mainly used to:

i.                 Avert or Limit Risks which individuals and organizations face during ordinary situations thereby saving costs and increase in return.

ii.               Enhance efficiency in trading by allowing free trade of risk components which allows traders to use a position in derivative to substitute a position in the underlying asset. It also offers a greater amount of liquidity and lower transaction costs to traders as compared to transacting the underlying asset cash market.

 

HISTORY:

It may come as a surprise that Asia's oldest stock exchange, Bombay Stock Exchange, started at the same time when the Bombay Cotton Trade Association started futures trades. In 1875, the Association started futures trading in cotton and related commodities. However, it was in 2000, when SEBI formally permittedthe Stock Exchanges to initiate trading in index futures contracts based on S&P, CNX, Nifty and Sensex in NSE[3] and BSE. This move came upon following recommendations of the L.C. Gupta committee which was tasked with drafting a policy framework for index futures.[4] The Gupta Committee provided a perspective on separation of regulatory responsibility between SEBI and Stock Exchange and recommended that SEBI should only authorize the rules, bye-laws, and regulations of a derivatives exchange.[5]

 

GROWTH OF DERIVATIVES MARKET

Several studies have been conducted over the years to find out the reasons behind the ever-growing trend of Indian Derivatives Market. To highlight a few, Shalini and Raveendra (2014)[6]attempted to study the Indian Derivatives Market and its position in the Global Financial Derivatives Market and concluded that the Derivatives market has a major and significant contribution to the development of the Indian Financial System. Vipul Kumar Singh (2016)[7] did a study on whether parliamentary elections create more ‘options contract’ in the derivatives market and concluded that Indian Parliamentary Elections do have a role in ups and downs in Indian Derivatives Market. By Mohammed Rubani (2017)[8] studied the factors which contributed towards the growth of the derivatives market in India and he found that price volatility, globalization, technological developments majorly contributed to the growth.

Statistically speaking, until 2007-08 single stock futures were traded at 57.66% share in total turnover when compared to the trading in other derivative instruments. However, from 2008-09, shares of options trading showed an upward trend from 3.69% in 2001-02 to get in double digits share in 2006-07 and reaching the rate of 11.70% in 2016-017, showing a shift from single stock futures to index options trading[9]. Credit should also be given to the awareness programs conducted as well as a Certificate course by NSE.[10]

 

COVID SITUATION

Compared to its predecessors, this pandemic proved to have a different type of situation. Unlike SARS, the spreading of coronavirus beyond expectation and vague anticipations about the virus slowdown has resulted in a bigger consequence than SARS 2003. Over 50% of the Indian Companies saw impacts on their operations and around 80% witnessed a decline in cash flows due to the Covid-19 situation.[11]Such facts led to unprecedented volatilityowing to fear of financial recession.

The data of derivative market volumes at NSE suggests that there was a fall of around 20% in the average daily traded derivatives contracts in March 2020. Furthermore, the number of contracts traded during the Indian lockdown period declined by over 45% when compared to two months' average the nos. A study suggests that the "measures taken by SEBI[12] to curb volatility could be the main reason for sharp fall in derivatives market”[13] It suggested that 'because of calibrating rules to manage speculations and volatilitstakeholdersorking of the market got disturbed by such incentives and shadowed mood and perception of stake holders in the economy.’

FUTURE:

A survey conducted by the trade association for the swaps and derivatives industry,‘The International Swaps and Derivatives Association’ ("ISDA") explored the impact of coronavirus pandemic on derivatives market liquidity. It highlighted that the main reason behind illiquidity was reduced risk-taking nature of banks and sudden need for short term funding of corporates. This crisis resulted in trading in smaller quantities. To cover such crises, unconventional tools used by RBI[14] to pump in money and to manage liquidity for the smooth functioning of the market is very appreciated. However, such temporary measures were advanced only to provide essential financial and monetary policy situation and to avert 2008 crisis like situation[15] other factors like increase in U.S. - China Trade standoff  and the shrinking world trade[16] poses more threat in this interconnectedand related market[17]and can have larger implications then the Coronavirus crisis.

---

[1]Saikat Das & Ram Sahgal, NSE turns world’s largest exchange in derivatives trading. (Jan. 18, 2020)(Available onhttps://economictimes.indiatimes.com/markets/stocks/news/nse-turns-worlds-largest-exchange-in-derivatives-trading/articleshow/73359798.cms )

[2]Securities Contract Regulation Act (SCRA) 1956; Section 2(ac)

[3]“The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001, and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.”

[4]SEBI, Review of recommendations of Dr.L.C.Gupta Committee on Derivatives.(Dec. 18, 2002) (Available onhttps://www.sebi.gov.in/legal/circulars/dec-2002/review-of-recommendations-of-dr-l-c-gupta-committee-on-derivaties-_16779.html )

[5]SEBI Advisory Committee on Derivatives, Report on Development and Regulation of Derivative Markets in India, (September 2002) (Available onhttps://faculty.iima.ac.in/~jrvarma/reports/derivates.pdf)

[6]S, Ms & Raveendra, Penumadu. (2014). A Study of Derivatives Market in India and its Current Position in Global Financial Derivatives Markets. IOSR Journal of Economics and Finance. 3. 25-42. 10.9790/5933-0332542.

[7] Singh, V. Parliamentary elections create more 'options': Shreds of evidence from the world's largest democracy 'India'. J Asset Manag 17, 375–392 (2016). https://doi.org/10.1057/jam.2016.23

[8]Mohammed Rubani; A study of Structure and Functions of Capital Markets in India, International Journal of Business Administration and Management. ISSN 2278-3660 Volume 7, Number 1 (2017),(Available onhttps://www.ripublication.com/ijbamspl17/ijbamv7n2spl_17.pdf)

[9] Dr. Nalini R; PERFORMANCE OF EQUITY DERIVATIVES MARKET IN INDIA WITH SPECIAL REFERENCE TO NSE, Volume - 7, Issue- 1, January 2019 | e-ISSN : 2347 - 9671| p- ISSN : 2349 - 0187

[10] NSE to help people learn about stock market basics (Jan. 24, 2018) (Available on https://www.thehindubusinessline.com/markets/nse-to-help-people-learn-about-stock-market-basics/article7305473.ece)

[11] Coronavirus impact: Over 50% of India Inc sees an impact on ops, 80% witness fall in cash flow.(Mar 20, 2020) (Available on https://economictimes.indiatimes.com/news/economy/indicators/coronavirus-impact-over-50-of-india-inc-sees-impact-on-ops-80-witness-fall-in-cash-flow/articleshow/74726229.cms?from=mdr)

[12]Sebi extend derivative curbs up to May 28 as market remains choppy (Apr 20, 2020) (Available onhttps://economictimes.indiatimes.com/markets/stocks/news/sebi-restrictions-to-curb-market-volatility-extendethe d-till-may-28/the articleshow/75254631.cms?from=mdr )

[13]R., Narasimhan. (2020). Impact of COVID on Indian capital markets, https://www.researchgate.net/publication/342392859_Impact_of_covid_on_Indian_capital_markets

[14]Three RBI measures to provide liquidity in these tough times (28 Apr 2020) (Available on https://www.livemint.com/money/personal-finance/three-rbi-measures-to-provide-liquidity-in-these-tough-times-11588096678486.html. ) See also, RBI announces the second set of liquidity measures (Apr 17, 2020) (Available on

https://economictimes.indiatimes.com/news/economy/policy/rbi-announces-second-set-of-liquidity-measures/articleshow/75200986.cms)

[15] asset Pedersen ,Liquidity risk and the current crisis, (Nov. 15, 2008) (Available on https://voxeu.org/article/understanding-liquidity-risk-and-its-role-crisis )

[16] Edward Hadas, Globalisation is down but not out, (July 23, 2020) (Available onhttps://www.reuters.com/article/us-global-economy-breakingviews/breakingviews-hadas-globalisation-is-down-but-not-out-idUSKCN24O226)

[17] James Cumes, ‘Globalisation and Derivatives’. Available on ‘ http://druckversion.studien-von-zeitfragen.net/Globalisation%20and%20Derivatives.pdf

’

INTRODUCTION

On Jan. 2020, the news about National Stock Exchange made its way to the finance section of newspapers which read as “NSE turns world’s largest exchange in derivatives trading”[1]. It highlighted the achievement of NSE which became the world’s largest derivatives exchange marketplacein terms of trading volumes, thereby replacing the US-based CME group. It was certainly a piece of very good news especially when Covid-19 fears had started shadowing over the securities exchanges all over the world. But an obvious question arises about what this meant to Indian Securities markets and what will be its future, especially after the pandemic?

WHAT ARE DERIVATIVES?

Before we dive into the pith and substance of derivatives, let us first try to understand what a derivative is. In formal terms, Derivative is a product whose price is derived from other variable called ‘bases’ which can either be an underlying asset like equity, forex, commodity, etc., or index or reference rate[2]. For ex., when we talk about flour, we know that it's derived from wheat and if there is any price fluctuation in wheat, it shall certainly affect the prices of flour. Here flour is derivative of wheat.Suppose a farmerwishes to sell his wheat on a later date but to eliminate any risk of changing prices, he enters a contract with the shop owner to sell his produce at a fixed price which shall be the price at the time of contract. Such a transaction is called ‘Derivative’ and the process of deriving ‘spot price’ is called ‘underlying.

From the above example, it can be concluded that Derivative refers to a broad class of instruments which derive its value from the price and other related variables of an underlying asset. It is mainly used to:

i.                 Avert or Limit Risks which individuals and organizations face during ordinary situations thereby saving costs and increase in return.

ii.               Enhance efficiency in trading by allowing free trade of risk components which allows traders to use a position in derivative to substitute a position in the underlying asset. It also offers a greater amount of liquidity and lower transaction costs to traders as compared to transacting the underlying asset cash market.

 

HISTORY:

It may come as a surprise that Asia's oldest stock exchange, Bombay Stock Exchange, started at the same time when the Bombay Cotton Trade Association started futures trades. In 1875, the Association started futures trading in cotton and related commodities. However, it was in 2000, when SEBI formally permittedthe Stock Exchanges to initiate trading in index futures contracts based on S&P, CNX, Nifty and Sensex in NSE[3] and BSE. This move came upon following recommendations of the L.C. Gupta committee which was tasked with drafting a policy framework for index futures.[4] The Gupta Committee provided a perspective on separation of regulatory responsibility between SEBI and Stock Exchange and recommended that SEBI should only authorize the rules, bye-laws, and regulations of a derivatives exchange.[5]

 

GROWTH OF DERIVATIVES MARKET

Several studies have been conducted over the years to find out the reasons behind the ever-growing trend of Indian Derivatives Market. To highlight a few, Shalini and Raveendra (2014)[6]attempted to study the Indian Derivatives Market and its position in the Global Financial Derivatives Market and concluded that the Derivatives market has a major and significant contribution to the development of the Indian Financial System. Vipul Kumar Singh (2016)[7] did a study on whether parliamentary elections create more ‘options contract’ in the derivatives market and concluded that Indian Parliamentary Elections do have a role in ups and downs in Indian Derivatives Market. By Mohammed Rubani (2017)[8] studied the factors which contributed towards the growth of the derivatives market in India and he found that price volatility, globalization, technological developments majorly contributed to the growth.

Statistically speaking, until 2007-08 single stock futures were traded at 57.66% share in total turnover when compared to the trading in other derivative instruments. However, from 2008-09, shares of options trading showed an upward trend from 3.69% in 2001-02 to get in double digits share in 2006-07 and reaching the rate of 11.70% in 2016-017, showing a shift from single stock futures to index options trading[9]. Credit should also be given to the awareness programs conducted as well as a Certificate course by NSE.[10]

 

COVID SITUATION

Compared to its predecessors, this pandemic proved to have a different type of situation. Unlike SARS, the spreading of coronavirus beyond expectation and vague anticipations about the virus slowdown has resulted in a bigger consequence than SARS 2003. Over 50% of the Indian Companies saw impacts on their operations and around 80% witnessed a decline in cash flows due to the Covid-19 situation.[11]Such facts led to unprecedented volatilityowing to fear of financial recession.

The data of derivative market volumes at NSE suggests that there was a fall of around 20% in the average daily traded derivatives contracts in March 2020. Furthermore, the number of contracts traded during the Indian lockdown period declined by over 45% when compared to two months' average the nos. A study suggests that the "measures taken by SEBI[12] to curb volatility could be the main reason for sharp fall in derivatives market”[13] It suggested that 'because of calibrating rules to manage speculations and volatilitstakeholdersorking of the market got disturbed by such incentives and shadowed mood and perception of stake holders in the economy.’

FUTURE:

A survey conducted by the trade association for the swaps and derivatives industry,‘The International Swaps and Derivatives Association’ ("ISDA") explored the impact of coronavirus pandemic on derivatives market liquidity. It highlighted that the main reason behind illiquidity was reduced risk-taking nature of banks and sudden need for short term funding of corporates. This crisis resulted in trading in smaller quantities. To cover such crises, unconventional tools used by RBI[14] to pump in money and to manage liquidity for the smooth functioning of the market is very appreciated. However, such temporary measures were advanced only to provide essential financial and monetary policy situation and to avert 2008 crisis like situation[15] other factors like increase in U.S. - China Trade standoff  and the shrinking world trade[16] poses more threat in this interconnectedand related market[17]and can have larger implications then the Coronavirus crisis.

---

[1]Saikat Das & Ram Sahgal, NSE turns world’s largest exchange in derivatives trading. (Jan. 18, 2020)(Available onhttps://economictimes.indiatimes.com/markets/stocks/news/nse-turns-worlds-largest-exchange-in-derivatives-trading/articleshow/73359798.cms )

[2]Securities Contract Regulation Act (SCRA) 1956; Section 2(ac)

[3]“The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001, and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.”

[4]SEBI, Review of recommendations of Dr.L.C.Gupta Committee on Derivatives.(Dec. 18, 2002) (Available onhttps://www.sebi.gov.in/legal/circulars/dec-2002/review-of-recommendations-of-dr-l-c-gupta-committee-on-derivaties-_16779.html )

[5]SEBI Advisory Committee on Derivatives, Report on Development and Regulation of Derivative Markets in India, (September 2002) (Available onhttps://faculty.iima.ac.in/~jrvarma/reports/derivates.pdf)

[6]S, Ms & Raveendra, Penumadu. (2014). A Study of Derivatives Market in India and its Current Position in Global Financial Derivatives Markets. IOSR Journal of Economics and Finance. 3. 25-42. 10.9790/5933-0332542.

[7] Singh, V. Parliamentary elections create more 'options': Shreds of evidence from the world's largest democracy 'India'. J Asset Manag 17, 375–392 (2016). https://doi.org/10.1057/jam.2016.23

[8]Mohammed Rubani; A study of Structure and Functions of Capital Markets in India, International Journal of Business Administration and Management. ISSN 2278-3660 Volume 7, Number 1 (2017),(Available onhttps://www.ripublication.com/ijbamspl17/ijbamv7n2spl_17.pdf)

[9] Dr. Nalini R; PERFORMANCE OF EQUITY DERIVATIVES MARKET IN INDIA WITH SPECIAL REFERENCE TO NSE, Volume - 7, Issue- 1, January 2019 | e-ISSN : 2347 - 9671| p- ISSN : 2349 - 0187

[10] NSE to help people learn about stock market basics (Jan. 24, 2018) (Available on https://www.thehindubusinessline.com/markets/nse-to-help-people-learn-about-stock-market-basics/article7305473.ece)

[11] Coronavirus impact: Over 50% of India Inc sees an impact on ops, 80% witness fall in cash flow.(Mar 20, 2020) (Available on https://economictimes.indiatimes.com/news/economy/indicators/coronavirus-impact-over-50-of-india-inc-sees-impact-on-ops-80-witness-fall-in-cash-flow/articleshow/74726229.cms?from=mdr)

[12]Sebi extend derivative curbs up to May 28 as market remains choppy (Apr 20, 2020) (Available onhttps://economictimes.indiatimes.com/markets/stocks/news/sebi-restrictions-to-curb-market-volatility-extendethe d-till-may-28/the articleshow/75254631.cms?from=mdr )

[13]R., Narasimhan. (2020). Impact of COVID on Indian capital markets, https://www.researchgate.net/publication/342392859_Impact_of_covid_on_Indian_capital_markets

[14]Three RBI measures to provide liquidity in these tough times (28 Apr 2020) (Available on https://www.livemint.com/money/personal-finance/three-rbi-measures-to-provide-liquidity-in-these-tough-times-11588096678486.html. ) See also, RBI announces the second set of liquidity measures (Apr 17, 2020) (Available on

https://economictimes.indiatimes.com/news/economy/policy/rbi-announces-second-set-of-liquidity-measures/articleshow/75200986.cms)

[15] asset Pedersen ,Liquidity risk and the current crisis, (Nov. 15, 2008) (Available on https://voxeu.org/article/understanding-liquidity-risk-and-its-role-crisis )

[16] Edward Hadas, Globalisation is down but not out, (July 23, 2020) (Available onhttps://www.reuters.com/article/us-global-economy-breakingviews/breakingviews-hadas-globalisation-is-down-but-not-out-idUSKCN24O226)

[17] James Cumes, ‘Globalisation and Derivatives’. Available on ‘ http://druckversion.studien-von-zeitfragen.net/Globalisation%20and%20Derivatives.pdf’