Policy dilemma on derivatives migration

Offshore locations account for a major share of Indian derivatives trade but experts say the rule relaxations needed to reverse the trend have other effects

Despite several attempts by the central government and the markets regulator, the export of Indian derivative markets to destinations such as Singapore and Dubai continue to threaten the domestic markets.

According to official data, the total number of Nifty active contracts on the National Stock Exchange (NSE) is 367,730. As compared to 496,198 on the Singapore Exchange (SGX). Similarly, for rupee-dollar futures, there are a total of 3.8 billion active contracts offshore (including SGX, Dubai and Chicago), against 3.1 bn on the NSE, BSE and MSCI put together.

This migration is largely on account of higher transactional costs, stricter regulations here and also lack of adequate flexibility in the domestic market, experts say. Also, offshore markets offer far more flexible timings to cater for investors across time zones. Although the government can provide relaxations on several fronts to enhance India’s competitiveness, most of the options would have side effects. And, any major change would impact tax collection or potentially lead to manipulation.
 

“There are also some issues at the fundamental level which need to be addressed, to attract more investors into the Indian futures market. One of the key issues for the currency market is that the rupee is not completely convertible. Also, rules and position limits around Indian derivatives are comparatively stringent and, hence, discourage investors like daily traders, an important part of the market system, as they enhance liquidity and enable better price discovery,” said Sudhir Bassi, partner, Khaitan & Co.

 

There are also several operational and taxation measures that investors have been seeking to contain this migration. However, none of the big reforms seem possible without a collateral impact.

For instance, a key demand of the foreign institutional investors (FIIs) is to do away with the Securities Transaction Tax (STT). This is levied on every order they place from an Indian stock exchange, raising their transaction costs. India is the only major market in the world that charges an STT-like tax on equity and derivative purchases.

However, one key challenge in doing away with STT is its link with the capital gains tax regime. STT was introduced in 2004, after the government provided investors an exemption on capital gains tax for securities owned for more than a year. Hence, any tinkering to the STT structure could lead to changes in the current capital gains regime.

Another demand from the sector has been on doing away with or increasing the limits on currency derivatives. For instance, the current rules say gross open positions across the segment cannot exceed 15 per cent of the total Open Interest (contracts not settled at the end of a trading period). This limits the extent of participation by several banks and overseas funds, which use the market not only for hedging purposes but for trading. The idea in bringing such a framework was to curb excessive speculation around the rupee, which could adversely impact the currency's value.

Over recent months, foreign institutional investors (FIIs) have also been asking the regulator, Securities and Exchange Board of India (Sebi), to loosen the restrictions around Participatory Notes (p-notes) for investment into the derivative markets. In a circular this July, FIIs were banned from issuing p-notes for any purpose other than hedging. This forced many FIIs to exit the Indian markets; p-notes worth Rs 40,000 crore were unwound during the August expiry.

“As an unintended consequence of Sebi’s move to check derivative participation through p-notes, some of the overseas investors are now moving to offshore locations. P-notes are very convenient instruments for many FIIs, due to the flexibility and speed of issuance. Given the tightened Know Your Customer (KYC) norms, the instruments can no longer be used for purposes such as money laundering. Hence, Sebi could consider relaxing the curbs imposed on p-note participation in the futures market,” said Tejesh Chitlangi, partner, IC Universal Legal.

 

The plan to counter destinations like SGX via Gujarat International Finance Tec-City (GIFT) doesn’t seem to be working at this point. Investors from GIFT get several privileges, including exemption from STT; however, the costs are still considered higher, as the tax that FIIs finally pay is still higher.