## Tuesday, July 29, 2014

### Concerns about individual investors on the Indian equity derivatives market

by Nidhi Aggarwal, Rohini Grover, Susan Thomas.

A recent article in the Business Standard by Praveen Chakravarty and T. V. Somanathan questions the quality of the Indian equity derivatives market. India is ranked next only to South Korea in terms of both the intensity of derivatives to spot traded volumes and the dominance of retail participation in derivatives trading. It is argued that complex financial instruments are better suited to the requirements of sophisticated institutional investors.

Korea has tried to reduce the large fraction of retail participation in their derivatives markets by increasing the minimum contract size twice between 2012 and 2014. The authors suggest that India consider taking similar action, or increase securities transactions taxes, to deflect retail interest in equity from derivatives trading to spot trading.

### Facts about retail investors and their dominance in equity derivatives trading in India

The article says there are "97% retail speculators", and later says there are 83-87% of both retail and proprietary trading. What are the facts?

Exchanges record every trade as a pair of buy and sell orders originating from a specific participant category. There are three broad categories of participant. Custodian trades which mark trades by institutions. Proprietary trades which mark trades by brokers for their own account. The remainder, which are Neither custodian or proprietary trades, are recorded as the retail investor, which include individual investors along with others. Not all that is not an institutional trade is a trade by an individual investor.

We focus on the fraction of the derivatives trade the options, both options on Nifty and single securities. In trading on these instruments, the shares are:

• Nifty options where daily traded volumes are around Rs.1200 billion
• Institutions = 20%
• Proprietary = 48%
• Neither (retail) = 32%
• Stock options where daily traded volumes are just under Rs.100 billion
• Institutions = 17%
• Proprietary = 42%
• Neither (retail) = 41%
Thus, retail individual investor participation are just 30-40 percent of the options trading in Indian equity.

### Korean thinking on reducing retail participation

A series of research papers using trade data from Taiwan and Korea found some evidence that individual investors consistently made losses on their trades, and that institutional investors made profits at their expense on average. Such evidence led Korean regulators to explore interventions to reduce the participation of individual investors in these markets and thus, minimise their losses. Their solution to the problem was to increase the minimum contract size so that individual investors find it more expensive to participate in the market, and reduce the positions they take.

Is this malady present in India? We don't know. Would the Korean treatments pass the cost-benefit analysis as required by the Handbook? We don't know.

In order to carry out a regulatory intervention to improve customer protection, it is first important to establish a market failure. We need to establish that there are such investors who are consistently losing. In order to do consumer protection, we must:
1. Understand whether the Korean empirical regularities hold in India;
2. Establish WHY this is so;
3. Establish a set of optimal alternative regulatory interventions;
4. Do a cost-benefit analysis of each a la the Handbook; and
5. Do a phased roll-out of the interventions and post-hoc analysis to see if the correct effect is achieved in terms of market outcomes.
The Koreans had the first step done for them (establishing that there is a problem), and by the looks of it, are still searching for solutions. The present state of knowledge on household finance in India does not answer these questions. We don't know if the malady is present, so the question of the treatment cannot arise.

### What ails institutional participation?

The BS piece presents the participation of various players on the Indian derivatives markets as based on choice of both institutional investors, and the others. However, institutional investors have often been kept out of these markets by regulation. Examples:
• IRDA has given in-principle approval but has not given operational clarity for equity derivatives trading by insurance companies.
• Banks are not permitted to do equity derivatives trading by RBI.
• Equity mutual funds lack operational clarity on critical sub-components of equity derivatives trading.
• FII participation has been hampered by capital controls and the messy transition into the FPI framework. Trading in the overseas OTC derivatives market (the "PN" market) is hampered.
• The onshore OTC equity derivatives market is banned.
• Position limits are tiny and do not address the requirements of institutional investors.
This market does not have institutional investors because they are being systematically kept out by regulators.

On a related note, the regulation of currency derivatives is also riddled with mistakes.

### The large ratio of derivative to stock traded volume

The discomfort of a much larger traded volume in the derivative compared to the spot is an age-old one, based on fears are that (a) derivatives markets lead to higher volatility, (b) there is market abuse deriving from the leverage of derivatives, and (c) small investors get consistently and persistently hurt.

These fears are not borne out by the facts. Over the entire period that India has had equity derivatives, the volatility has come down, there has been little evidence of a larger incidence of market manipulation in stocks with derivatives, and liquidity has improved.

A research paper from the Finance Research Group analysing the single stock futures markets in India offers a possible explanation for these large derivatives volumes. This paper suggests that in markets where there are severe funding constraints there is a larger participation in derivatives, because these leveraged products allow traders to preserve the efficiency of their trading capital. These funding constraints can be for several reasons. Partly, it could be because emerging economies have a shortage of capital. Partly, it could be because institutional investors who have the capital are forcibly kept out of participating in securities markets. Other mistakes of regulation which are shaping this outcome include the failures on securities lending which hampers short selling.

The paper finds that the Indian markets have the highest dominance of price discovery in equity derivatives compared to what has been recorded in all the other literature on this subject. Information is flowing from the derivatives into the spot prices in Indian equity.

### Conclusion

We should be do thorough homework before introducing regulations that interfere with the freedom of private persons. Most of the ills of Indian finance derive from weak financial economics, and lack of due process, at regulators. The solution lies in fixing the regulatory process and not in further reducing freedom.

Finance Reseach Group, IGIDR, Bombay

## Saturday, July 19, 2014

### What does socialism do to ethics

Marginal Revolution has a post about the moral effects of socialism. In this, we are pointed to a fascinating new paper. Ariely, Garcia-Rada, Hornuf, Mann have a new paper where they analyse the natural experiment of one Germany that was arbitrarily sub-divided into communist GDR and capitalist FRG. They find that people with a greater exposure to socialism are more likely to cheat.And, a paper by Al-Ubaydli et al on PLOS One in March 2013 finds that the framework of markets and trade increases trust in strangers.

I have heard similar concerns about low ethical standards in China as the outcome of many generations of communist rule.

Was it just a matter of stamping out religion? Is the causal chain composed of destroying organised religion that leads to cheating by individuals? This does not square with some other evidence. This paper by Gregory S. Paul in the Journal of Religion & Society finds that highly secular democracies consistently enjoy low rates of societal dysfunction.

In the comments on the Marginal Revolution post, mm says that P. J. ORourke says that he knew communism was not going to work when it managed to convert Germans into lazy workers.

These ideas resonate for us in India, with our experiences with the corruption and cheating that is associated with government-controlled resource allocation. There is a fundamental tension between socialism and our core aspirations like the rule of law, a Calvinist work ethic, and fairness and honesty in our dealings. What mechanisms might be at work in the corrosion of values under socialism? From my observation of India, I may conjecture:
1. When things are available through connections or the black market, this gives everyone incentives to engage in illegality, and to violate the rule of law. When storage is proscribed as hoarding' and forecasting the future becomes black marketing', people get used to the idea that illegal activities are to be pursued, and the people who are willing to engage in greater illegality get ahead in life.
2. In the parts of India where land reform took place, it became more acceptable to steal other people's stuff.
3. People became supplicants in front of a powerful State, and detested the bureaucrats and politicians who wielded discretionary power. This created pervasive hatred and disrespect for the State, an environment that was conducive to breaking laws more frequently.
4. When inequality is bemoaned and envy becomes fashionable, there is reduced incentive to engage in hard work as a tool to get ahead in life.
5. A big State employs more people, and employees of government and public sector companies tend to have a diluted work ethic.
6. There is a big gap between all the talk about poor people and the reality of the socialist State. This breeds cynicism about politics and government, and fewer wonderful people get involved in matters of the State.
7. When the political leadership allocates time and money to doing central planning and running welfare programs, this comes at the expense of time and money focused on catching crooks.
If we are able to retreat from an intrusive State, and build the rule of law for a narrow set of interventions that do public goods and address market failures, this will help create a new tone of flesh in the Republic. But the changes in behaviour that come with a socialist phase take many decades to get stamped out. We should change things from here on -- but we will live with the consequences of Indian socialism for a long time.

Hence, questions about ethics are going to be a key feature of the Indian story for years to come. I have written before on related themes: Indian capitalism is not doomed, and Ethics and entry barriers. There are now 40 posts on this blog with the label `ethics'.

## Wednesday, July 02, 2014

### Securities lending: A key missing link in the Indian securities markets

by Rohini Grover.

### The importance of securities lending

Securities lending is a temporary exchange of securities between two parties against some collateral with an obligation to return the borrowed securities at a future date. The collateral may be in the form of shares, bonds, or cash. It serves the following objectives:
1. It allows market participants to 'short-sell' by borrowing securities temporarily. A well functioning securities lending and borrowing (SLB) market enables efficient execution of trading strategies based on short selling. For example, in cash and futures arbitrage, an arbitrageur will buy futures and short sell borrowed shares in the spot market if the futures price is lower than the spot price. This ensures that the futures price returns to its fair value and restores market efficiency.
There is ample research on the gains from short selling. E.g. Boehmer et al, 2008 shows that banning short selling lowers market quality as measured by spreads, price influence, and volatility. Recent research by Rajat Tayal and Susan Thomas suggests important links between short selling constraints and asymmetry in liquidity.
2. Investors with a long term investment horizon earn additional returns in the form of lending fees by lending securities. Portfolio returns go up when securities are lent, but there might be credit risk if there is inadequate collateral.
3. Additionally, in a money market, investors with large inventories of securities can post them as collateral to obtain short term finance.
The features of a well functioning SLB market include: wide market access with large number of borrowers and lenders; transparent regulation to mitigate uncertainty and encourage participation on both sides; and low transaction costs. Several countries like the US, Brazil and South Korea have established successful SLB markets. In India, while the equity market achieved transformative change, securities lending is the last big component which has not fallen into place.

### The Indian experience

The SLB market in India was introduced by the National Securities Clearing Corporation Ltd (NSCCL) on April 21, 2008. The market design featured automated screen based trading platform with online matching of trades based on price-time priority; all classes of investors permitted, including FIIs; settlement guarantee; and NSCCL as an Approved Intermediary acting as a Central Counterparty (CCP).

All over the world, securities lending is generally done OTC and generally involves credit risk. The Indian launch was quite novel in two respects: the emphasis on anonymous order matching (so as to remove the infirmities of OTC transacting) and the use of a clearinghouse which eliminated credit risk.

The Indian SLB market has grown through two distinct phases:
1. From 2008 - 2009: After introduction, the initial market volume was negligible. SEBI revised the SLB framework in October 2008 to tackle this. The key changes were: increasing SLB tenure from 7 days to 30 days; increasing trading timings from one hour to a full trading day; accounting for corporate actions such as dividends and stock splits. This phase was largely a failure.
2. From 2010 - present: Starting January 2010, a number of market microstructure changes were introduced to improve the segment's liquidity by easing participation. These steps increased volumes significantly in percentage terms, but in absolute terms it is still a highly inadequate market.

### Regulatory changes

Two broad regulatory themes emerged since 2010. Where SEBI amended the framework to improve market microstructure, IRDA widened the market by allowing insurance firms to participate.
The following are the details of the changes introduced by SEBI:
• SEBI circular: Jan 06, 2010 w.e.f June 28, 2010:
1. The tenure of SLB was extended to 12 months.
2. Early recall and early repayment facility were introduced.
3. In case of an early recall by lender, the clearing house will procure securities for the lender on a best effort basis. A fee will be charged to the lender seeking early recall.
4. In case of early repayment by the borrower, the clearing house will release the margins on the returned securities. It will try to lend these securities onward on best effort basis. If it is unable to do so, the borrower will have to forego the lending fee for the remaining period.
• SEBI circular: Nov 22, 2012 :
1. Liquid ETFs were introduced with position limits based on their AUM. Trading in these commenced in September, 2013.
2. A roll-over facility was introduced which provided roll over for 3 months (original + 2).
3. Netting of counter positions, i.e. netting between the "borrowed" and "lent" positions of a client was not allowed.
• SEBI circular: May 30, 2013:
1. New stocks (other than F&O stocks) were added to SLB. Trading in these started in July, 2013.
2. Collateral for margin obligations was made similar to that for cash market.
In addition to the changes introduced by SEBI, IRDA opened up SLB participation to insurance firms via IRDA guidelines: July 12, 2013. It limited lending to a maximum of 10% of the securities in the fund. In February 2014 (after an odd gap of six months) NSE clarified the position limits for insurance firms and other institutional investors via NSE circular: Feb 14, 2014. These were to be the same as that of a participant i.e. lower of 10% of the market wide position limit (MWPL) or Rs.50 crore.

### Outcomes

The enhanced flexibility, due to longer contracts and early recall and repayment, considerably improved the liquidity of the market. The four week average number of shares traded increased from 0.0006 million to 0.049 million after the implementation of the changes.
Provision of roll-over facilities and relaxation of collateral requirements had a modest impact. The former increased traded volume by 40% and the latter by only 7%.

The introduction of liquid ETFs and 46 new stocks was expected to increase the trading activity by widening the market. Nevertheless, with the onset of trading in ETFs, the market observed only a meagre 9% increase in the average number of shares traded in the four week period prior vis-a-vis the four week period after the change. Moreover, there was no significant change in these averages after the commencement of trading in new stocks. If anything, the traded volume dropped from 0.41 million to 0.32 million.

Permitting insurance firms to trade in the market was a positive move by IRDA because it added to the shallow lending side ailing the SLB segment. Once again, the step yielded insignificant gains. On Feb 14, 2014, when the position limits for insurance firms and other institutional investors were revised to the participant level, the liquidity improved dramatically clocking a 70% increase in average number of shares traded after revision.

### Diagnosing the failure

Since the securities loan is made on the exchange platform and covered by the clearing house, there is no risk to the lender of not receiving the lending fee. However, the risk of not procuring the security lent, on early recall, persists.

In an early recall the lender has to quote the lending fee he is willing to forego for the balance period. However, an early recall request is fulfilled by the clearing house on a best effort basis only – the exchange does not guarantee liquidity so that there is a matching order on the other side offering securities to the recall order. The lender has to wait for a match to his early recall order, failing which, he will have to keep the loan position open till the reverse leg day.

Suvanam and Jalan (2012) find that the SLB market in India has typically been a borrower-driven market with the presence of few lenders. The borrowing side in India is primarily proprietary traders, whereas in other countries the borrowing side is more diversified and includes hedge funds, mutual funds, foreign investors etc. Market diversity and depth on both the sell and the buy side is essential for proper functioning of a market. Suvanam and Jalan (2012) conclude (pp. 27) that "such diversity is currently absent in the Indian SLBM".

Globally, pension funds are large players on the lending side but in India they are not allowed to participate. The investment guidelines under the Investment Management Agreement between the NPS trust and pension funds impose restrictions such as "the assets are not to be encumbered", and further, "the PF shall buy and sell securities on the basis of deliveries and shall in all cases of purchases, take delivery of relative securities and in all cases of sale, deliver the securities and shall in no case put itself in a position whereby it has to make short sale or carry forward transaction or engage in badla finance".

Suvanam and Jalan (2012) find that foreign investors constitute 90% of the buy side and 86.4% of the sell side in the South Korean SLB market – another market that limits the segment to only the exchange. The Indian segment may also benefit from easing FII participation norms. While domestic institutional investors are likely to require time to understand the mechanism and set up processes to participate, FIIs are likely to be rapid entrants into this market.

There are numerous mistakes in regulations which have to be fixed in order to open up the market for FIIs:
1. RBI's rules for FII participation in the SLBM prescribe that shares may be borrowed only for short selling. There is no clarity on what happens if the FII sells short and is unable to procure stock in the SLB market.
2. FIIs must maintain collateral only in the form of cash while domestic institutional investors have a wider range of collateral options such as cash, fixed deposit receipt, bank guarantees and most recently included Gsecs and T-bills.
3. FIIs may need to access the SLB market despite having stock in their portfolio. FIIs may hold an omnibus account while client positions are maintained internally. This warrants participation in SLB for one client while the FII holds stock for another. The regulatory stance on this is unclear.
4. The RBI prohibits NRIs from participating in the SLB market.
The client level position limit of 1% of MWPL is too small especially for institutional investors. The presence of extremely low limits on trading ETFs may be a reason for their failure in improving liquidity. For example, the market wide position limits in NIFTYBEES for June 2014 was 548,557 shares. Hence, the client level position was 5,486 shares (1% of MWPL) which is ridiculously small.

An over the counter (OTC) market provides greater contract flexibility and wider position limits that encourage greater participation. The low volumes in India may, in part, be because the Indian regulator has limited the SLB segment to the exchange – unlike the US which is primarily an OTC market and Brazil which allows trading in SLB on both the exchange and OTC.

### The way forward

1. Removing lenders' risk: Absence of a settlement guarantee mechanism in case of early recall by lenders erodes incentives for large lenders to enter the market. The existing SLB framework does not provide such a guarantee (SEBI circular: Jan 06, 2010). In contrast, the CCP in South Korea provides settlement guarantee for a fee. In Hong Kong, the CCP forces borrowers to return the securities to the lender in case of early recall. The Indian regulator should either adopt a model for providing this guarantee or at least provide monetary compensation in lieu of it.
2. Adding pension funds to the list of lenders: It will be useful for PFRDA to invite debate about the costs and the benefits of allowing participation of pension funds in the Indian SLB market. Guidelines similar to those released by IRDA for insurance firms should be issued to allow their participation.
3. Increasing FII participation: The RBI rules: Dec 31, 2007 permit only cash collaterals for FIIs. Given that RBI already allows FIIs to maintain a wide range of collaterals in the equity and F&O segment, this could easily be extended to the SLB segment. Also, there should be clarity on issues such as failure to procure the securities lent and access to SLB market when they already hold stocks in their portfolio.
4. Increasing position limits: SEBI and the exchanges should reconsider the client level positions. They should seek market consultation and set position limits accordingly.
5. Establishing a parallel OTC market: The SEBI circular: Dec 20, 2007 states 'that stock exchanges shall put in place, a full fledged securities lending and borrowing (SLB) scheme, within the overall framework of "Securities Lending Scheme, 1997".' It designates clearing houses/corporations of stock exchanges as the Approved Intermediary under the Securities Lending Scheme, 1997. This prohibits an OTC market in the SLB market. As Suvanam and Jalan (2012) note "a parallel OTC market with a CCP or without a CCP can augment this market." The regulator must invite debate with market participants and researchers to consider this possibility with the objective of improving liquidity.

### Difficulties with PFRDA's Draft Aggregator Regulations, 2014

by Arjun Rajagopal and Renuka Sane.

Recent mis-selling scandals in retail finance in India have brought into focus the dangers of unregulated, or lightly regulated financial intermediation. Financial intermediaries include banking correspondence agents, micro-finance institutions, insurance agents and other such players. They extend the reach of formal finance to a vast under-served population that is dispersed and not yet electronically enabled. Under-served populations with low access to finance are likely to be economically vulnerable, and may also have low levels of financial literacy. This makes them more dependent on the financial intermediaries they interact with, and more vulnerable to mis-selling and outright fraud. Such populations are also likely to have poor access to grievance redress mechanisms, courts and social safety nets.

The micro-finance crisis in Andhra Pradesh in 2010 shows what happens when regulators get it wrong. Loan collection agents in Andhra Pradesh were accused of engaging in large-scale coercive practices. This resulted in a political backlash, from which the industry is still reeling. It is therefore extremely important that India's financial regulators get it right when it comes to regulation of financial intermediation. This includes placing an appropriate emphasis on consumer protection.

Like loan collection agents in the case of micro-finance, aggregators in the pensions industry are a major interface with low income households in the informal sector. Aggregators are used to implement the NPS-Swavalamban (NPS-S) scheme run by the Pension Fund Regulatory and Development Authority (PFRDA). Under this scheme, if a subscriber in the informal sector contributes a minimum of Rs.1000 into her NPS-S account in a financial year, she will receive a co-contribution of Rs.1000 from the government. Aggregators market the scheme, enroll members and continue to service members post enrollment. They also make the investment choice for their customers. Aggregators thus act as execution agents of the NPS-S and as advisors to consumers. This means that aggregators potentially have considerable influence over financial choices of low-income households. Regulators should be very alert to the risk of fraud or mis-selling by these aggregators for three reasons:

1. The consequences of fraud or mis-selling in the case of a product such as the NPS-S will probably only be detected far in the future, at the time of receipt of benefits.
2. Older people are less likely to be able to recover from a sudden loss of income, especially if they have chosen to rely on income from the NPS-S.
3. Public sector involvement in commercial products often gets construed as an official endorsement of the product. This exacerbates the risk of mis-selling.

Any regulation of aggregators must therefore place great emphasis on the goal of consumer protection.

### The Draft Aggregator Regulations, 2014

Consumer protection is one of the pillars of the draft Indian Financial Code (IFC). The PFRDA, along with the rest of India's financial sector regulators, has committed itself to voluntarily implementing the consumer protection dimensions of the IFC, as articulated in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code . The recently released Draft Aggregators Regulation, 2014 are viewed in this context.

The Draft Regulations do recognise the importance of consumer protection as described in the IFC. They set out registration details of the aggregators, their duties and responsibilities and the inspection and disciplinary procedures that the PFRDA may initiate. Schedule VI of the regulations provides the aggregators with a code of conduct. However, we believe the regulations do not go far enough. Here is where the regulations fall short:

• The regulations do not provide well-defined standards of skill and care that aggregators will be expected to exercise towards a customer. The beauty of simple, well-designed products is that they can be sold by agents with even basic financial literacy. However, it is important to specify what that basic level is for a given activity, or at least the standard that will be used to determine that level.
• The regulations do not define what constitutes unfair and misleading conduct by aggregators. The Handbook discusses the need for regulations defining unfair and misleading conduct. India's experience with coercive and unfair practices by intermediaries should highlight the need for such definitions to be carefully researched and well-thought through.
• The regulations do not place obligations on the aggregator regarding protection of consumers' personal information. In the context of digitisation and aggregation of information by private and public entities, it is increasingly important for regulators to specify these obligations.
• The regulations do not provide adequate guidance for avoiding conflicts of interest. Subscribers of the NPS-S often purchase the pension scheme at the time of taking a micro-finance loan. The aggregator may be the intermediary for both these products. This scenario is entirely plausible, and is a foreseeable circumstance in which there may be a conflict of interest. However, the draft guidelines are silent on providing guidance on how aggregators should think about this issue, or the information that they must provide to clarify such conflicts.
• The regulations do not provide adequate guidance regarding disclosures. Most NPS-S sales today rest on the co-contribution by the Government. It is not certain that this co-contribution will continue after 2017. This is information known to the aggregators, which is highly relevant to potential purchasers of the pension scheme. However, the regulations do not contain any details about such initial and continuing disclosures.
• The regulations do not require any suitability or appropriateness checks before selling the NPS-S. The NPS-S is a market-linked, illiquid product. An illiquid product with a minimum contribution may not be appropriate for consumers who require cash in hand in the near future. By extension, investing in the NPS-S and simultaneously taking a micro-finance loan may not be a prudent decision for many consumers. Suitability analysis is an important part of the draft IFC's consumer protection for retail consumers. The regulator may take a view that the NPS-S is not a complex product, and therefore does not require suitability checks. In this case, the regulator needs to articulate the reasons why suitability checks are not mandatory. Absent such a justification, the regulations should feature some guidance on the issue of suitability.

The UK's experience with financial regulation shows that broad principles of consumer protection need to be translated into detailed guidance notes, such that both the regulator and the industry understand what is expected.

### PFRDA has not used the appropriate processes for framing regulations.

In addition to the substantive concerns listed above, the regulations fail to abide by the procedural requirements of the Handbook, for framing regulations. The PFRDA should have provided the following:

1. A clear statement of objectives;
2. A list of problems the regulation seeks to solve; and
3. A cost benefit analysis of each of the provisions.

The Handbook places major emphasis on the process of soliciting public comments via a well-designed web interface. Examples of such interfaces include the US Commodities Futures Trading Commission public comments page. There is as yet no information about the public comments received by the PFRDA.

### Conclusion: Re-do with better public participation

The role of the aggregators, and the vulnerability of their customers should have led the PFRDA to accord a high importance to consumer protection when framing these regulations. The PFRDA needs to revisit these regulations and revise them in accordance with the substantive and procedural requirements of the Handbook. In particular, it would be advisable for PFRDA to quickly upgrade its ability to receive and display public comments on draft regulations. The PFRDA might consider extending the period for public commentary, and engaging more actively with the public to obtain high-quality feedback on this important subject.