The Securities and Exchange Board of India's (Sebi) decision to ban badla and introduce options trading on stocks is expected to have long-term implications for the market. Both the stock exchanges and market participants are busy gearing up for the new system.
Amidst the excitement and confusion about the post-July 2, 2001 scenario, Gaurav Dua and Mobis Philipose spoke to Sanjiv Mehta, chief executive officer -- derivatives segment, Bombay Stock Exchange (BSE), about recent market developments and the future of the derivatives market in India.
How will the new system be beneficial for the markets? What has been the international experience?
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If you look at the international experience, derivatives have proved to be very successful in most of the countries. And generally the derivative volumes becomes the multiple of cash volumes.
One good example of this is the Korean stock exchange where futures and options are extremely popular. Derivatives were introduced in Korea in 1996 and within 12 to 18 months, the volumes in derivative markets became impressive, outpacing the cash market.
Moreover, there is a clear segregation between the cash and the derivatives market now. The cash market will be suitable for people with long-term investment horizon.
While derivatives are very flexible instruments that provide leverage and a chance for investors to express their views by taking a position in the derivatives market. Options are fascinating instruments that can provide hedging to the long-term investor in the cash market.
On the other hand, more sophisticated arbitrage players can take advantage of the price mismatch in the two stock exchanges BSE and NSE or between the cash and the derivatives market.
The new system will be beneficial to different classes of investors and make the markets more systematic and transparent.
So going by international experience, do you believe it will take about two years to generate substantial volumes in the options trading market? Could it take much longer considering the poor volumes in index futures trading in India?
Till now, investors were not seriously looking at derivative products such as index futures. This is because the market was quite comfortable with badla which as a product have different components to it.
But now, with the ban on badla, there is no alternative but to focus on derivative products.
About the time lag, yes, you are right that it might take sometime before we have sufficient volumes in the derivative market. But at the same time, we must understand that over the past few months many seminars and training sessions have been conducted.
Though there are certain issues that need to be tackled, the overall exchanges are more experienced now. And since we already have the software and systems for index futures in place, it will not be like starting afresh.
Moreover, in case of index futures, we were (for the first time) moving away from a single to a multiple product environment. So the risk management was a major challenge. That's because it had to be managed on a portfolio basis instead of individual stocks.
All these required system changes has already been accomplished. Thus, we have built up the required confidence and will not have similar problems now.
Are you concerned about the possible drop in volumes after the introduction of compulsory rolling settlement and options trading on July 2 this year?
This particular issue has been debated extensively and there are many different opinions. Whenever there is a change in the system and new products are introduced, there generally is some confusion.
But the new system also offers a lot of opportunities. There is no doubt that a lot of work has to be done in terms of investor awareness.
Both investors and intermediaries will have to devote time and learn at a very fast rate. But in the medium-to-long-term, the recent changes are beneficial to both investors and the markets.
Ultimately, both the cash and derivatives market would be synergistic. A healthy cash market helps the derivatives market and vice versa.
Normally, after the initial lag, volumes in the derivative market outpace that of the cash market. For instance, in the US, where the volumes are huge, the derivatives volumes are about 2.2 times greater than that of the cash market. It's the same in Germany.
In Singapore, derivative volumes are as high as 7.1 times that of the cash market -- but that is also because the internal cash market in Singapore is not very developed.
In fact, given the ease of use, derivatives are quite popular among the small and retail investors. For instance, in the Korean markets, about 40 per cent of the derivative volumes come from the retail segment. It was as low as three or four per cent in 1996-97 but grew steadily during the last couple of years.
What has been the response for the mock trading session held by your exchange? Do the participants understand the new system and are they clear about the trading strategies?
The response to the mock trading sessions was quite positive. All the slots were filled and there was a tremendous amount of interest among the investors.
In terms of understanding, the results have been mixed. Some of the players seems to understand the derivatives market very well -- perhaps, they have been proactive and prepared themselves.
Many other market participants need to gear up their act. As an exchange, it is a challenge for us to educate our members. Every fortnight, we hold sessions on options trading for our members in both derivative and cash market.
This is in addition to the courses provided by the BSE Training Institute. Besides, we have been offering a two-day course on derivatives for the past year and a half.
We also realised the need to offer customised courses for corporates and big brokerage houses. Moreover, for the benefit of certain participants, I personally will be conducting specialised workshops on how to manage and run an options risk book for certain large players who are quite prominent in the cash market.
All these initiatives seems to be aimed at training intermediaries and certain large market players. But have the exchanges taken any steps towards educating small investors? How will they benefit from the new system?
That has to be done through extensive dissemination of information. And that is where the media plays an important role. Right now, we are concentrating more on training intermediaries primarily because initially, the retail investor will require little bit of hand-holding and support from the intermediaries.
Like in any classical marketing example, there are early adopters who take the initiative and then gradually the others move in.
In terms of advantages to the investor, options can be very effectively used as a tool by banks and intermediaries to develop and structure certain products such as Capital Protected Notes (CPN) which are very popular in US and European markets.
For example, CPN can be structured as a Sensex-linked deposit in India where the return will depend upon the movement of the Sensex with absolutely no risk of capital loss.
Here, the banks or intermediaries will calculate the present value of interest on the capital and use that to buy a call option on the Sensex. The risk of the investor is only limited to the interest that could be earned on the capital.