The recent financial crisis might seem to superficially vindicate Warren Buffett’s characterization of derivatives as “weapons of mass destruction” but derivatives can be as useful for promoting market liquidity and risk-distribution, as it can be for naked speculation. It all depends on whether you are trading “naked” derivatives, or you are “covered” by either the underlying or an opposite position in a similar derivative (which dramatically reduces your risk)
Unfortunately, the leading exchanges of India have high margin requirements and often do not have margins for speculation strategies and arbitrage/insurance strategies when it comes to derivatives, especially options. This along with the Securities Transaction Tax or STT (and various state stamp duties in the pipeline) reduce market liquidity. Arbitrageurs do not find it worthwhile to invest their money and time in further reducing market spreads This is why single-stock options and even index options with expiry after two or three month are barely liquid.
A simple example is if you wanted to sell a call on a security that you own – if the stock increases in price, all loss on your sold option is neutralized by the gain you realize on your stock itself. But even in this risk-free scenario, NSE would still charge you a margin as if you do not own the underlying. This could be solved by simply requiring the NSE to collaborate with NSDL/CDSL to have a lien on the stock in lieu of the margin requirement, if the retail investor so allows to get lower margins. Also, suppose if you sell a deep out-of-the-money call, currently you would be required to pay unrealistically high margins. Yet the National Stock Exchange (NSE) seems to ignore this, although in its defence such “cross-margining” on futures-to-cash spreads is allowed.
This is because of the substantial market power that the NSE has in the Equity Futures and Options segment. But the solution would not require any anti-trust activism or margin fixing on the government’s part -instead the Securities and Exchange Board of India (SEBI) should expedite all applications and simplify future applications for other exchanges to open a derivatives counter, or any other counter for that matter. Competition would force the incumbents to be more dynamic and wean them off the easy float or interest they get from such irrationally high margins. Removing the insanely restrictive 5 percent limit for promoters in exchanges would also be a good step.
Derivatives after all can be the agents of mass prosperity too – farmers can buy wheat put options on exchanges to insure them against price falls and small importers can buy dollar calls to save themselves from rupee volatility. Moreover, India is a nation with a rich history of options trading – pre-Independence there were relatively huge volumes in commodity options, but the government of “free” India banned them in 1952. The government is liberalizing finance again, but remains wary of speculation. Yet speculators are often the counter-parties to hedgers, the very parties the government wants to help. Competition in margins along with reduction of transaction taxes and duties is required for that.
Note: Thanks to Rajeev Mantri, Sumit Jain and Ajay Agarwal for their technical inputs.
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