GN Bajpai: Cooling derivatives without distorting the market is no easy task

A consultation paper published by the Securities and Exchange Board of India (Sebi) noted that in 2023-24, an average 85 out of 100 individuals trading in index futures lost money. 

The market regulator’s solicitude seems to be the interest taken by common investors in derivatives, apart from the market’s efficacy and rhythm. Accordingly, Sebi has promulgated numerous measures to cool this market down.

Derivatives are a risk-management financial instrument. On one side of a trade is a risk-hedger, and on the other, a risk-taker. The latter is a kind of speculator who consciously bets on possibilities. Incidentally, derivatives also help in sharpening how the stock market prices stocks.

Broadly, there are three kinds of threats to the tranquillity of a securities market: structural risks, systemic risks and operational risks. Aberrations in trading, sudden and disproportionate surges in volume, misdemeanours and major market misconduct must be examined from all three angles. 

Often, only operational risks are in focus, with the low-lying systemic risk of ‘a banker not honouring a banker’s cheque’ overlooked. This contributed substantially to the global meltdown of 2007-08.

In India, an upsurge in derivative volumes, high interest in primary share issues (even by small and medium enterprises or SMEs) and widespread retail participation all warrant scrutiny from all three angles.

Shallow secondary research has indicated that the country’s savings-and-investment market structure is undergoing a transformation. Savers are taking direct charge of their investments and entrepreneurs are directly approaching the market for funding. 

Enthused by disintermediation gains of the internet era, investors and entrepreneurs alike have turned reluctant to pay for costly financial intermediation. The clock is running down on the role of institutions as intermediaries that use savings to finance businesses.

Many rants were aired in response to a recent two-wheeler dealer’s ₹12 crore offer of shares attracting bids of ₹4,800 crore. This was taken as a sign of IPO market mania. Dig deeper, though, and it’s best seen as symptom of today’s undercurrents of change.

First, venture capital funds have been vanishing from the Indian capital market, while private equity (PE) has turned risk-averse. From the original concept of expecting one of every 10 investments to succeed, PE players have largely begun looking for all 10 to assure them a return-on-investment of 25% and above.

Second, individual investors are ready to risk their surplus savings on equities, given how the Nifty-50 and BSE Sensex are perceived to deliver returns that are very high in the short-term, high in the medium-term and moderate in the long-term. 

Entrepreneurs, meanwhile, have been encouraged to raise money directly. Through a regulatory framework created in coordination with stock exchanges, Sebi has fashioned platforms for SMEs and startups to raise risk capital.

The capital market’s efficiency is gauged by the ease and cost of participation. Once investors are linked with entrepreneurs, all regulators—Sebi as the primary one and exchanges as secondary ones—must watch from the sidelines to ensure that the game is played fairly and the market’s efficacy and rhythm do not suffer.

The Indian economy is poised to stay on a high-growth trajectory for years to come and narratives of the national political executive have created positive vibes. 

Entrepreneurs are being asked to make the most of opportunities while investors are betting on this script. Fortunately, they have been rewarded handsomely in the last couple of years.

Anecdotal evidence suggests that many common investors are learning the ropes of managing the risks of investing in equity through daily swaps and other derivative products. Now they have more to grapple with. 

As regulatory actions have a propensity to raise operational and compliance costs and orchestrate market distortions, Sebi’s recent measures to cool down the derivatives market are also likely to have a fallout along these lines.

All regulators are accountable to the public and their accountability should be assessed on four criteria. Do they cite reasons for decisions? Are they exposed to public scrutiny? Do their decisions undergo an independent review? 

And do regulatory initiatives undergo an economic cost-benefit analysis? While Sebi meets the first two, independent reviews of its decisions have been missing. 

Also, crucially, their benefits do not seem to be weighed against their economic costs, and if they are, the process is not available for public scrutiny.

It is premature to comment on the trade-off between market protection and the adverse fallout of regulatory steps taken to cool off derivatives. As regulators often need to act pre-emptively in a hurry, ex-post analysis is essential. 

Sebi has access to academic resources at the National Institute of Securities Markets. Hopefully, it will put its latest measures—as well as others—under examination.