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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.


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


  1. I have a casual acquaintance with NIFTY and single stock options as a small time participant and I feel that one way to judge the efficiency of the of the equity derivatives is to study the lag by which a sudden correction in the cash market level gets priced in by the equity derivatives (in an arbitrage free world such adjustment should be instantaneous). However, as a participant , my experience has been that such cash to derivative transmission has been significantly slow in respect of single stock options. Moreover, the bid -offer spread in cases wherein there have been some transmission inevitably widens. There seems to be a few dedicated 'market makers' in some of the less liquid counters who seem to determine the pricing in those counters and seem to move the bid-offers in their favour. Obviously I cannot generalize my experience but I feel there seems to be a prima facie case of examining cornering / rigging in some of the less liquid option counters.

  2. 1: Casting aside ideologies of liberty and individual freedom, the argument here is one of public policy issue of the current structure of our markets and its utility in serving its economic purpose
    2: That derivatives is primarily an efficient hedging tool for investors which improves market efficiency doesn’t seem to be under dispute.
    3: FIIs and DIIs that own 90% of free float market cap and presumably should hedge their portfolios account for merely 15% of derivatives trading value.
    4: Retail investors as categorized by NSE data, whose ownership in equity markets is 7% of free float account for 40% of derivatives’ trading value. Clearly, this implies significant amount of speculative trading.
    5: As per NSE’s classification of data, if there is a category called Institutional Investors, Retail and Proprietary, it is an accurate inference that the Retail and Prop categories are non-institutional. If derivatives is primarily a hedging tool for sophisticated institutional investors, then NSE’s data shows that between 87.6% to 83.5% of derivatives volume by value is by non-institutional investors over the last 10 years.
    6: It is reasonable to assume that FIIs and DIIs have abilities to hedge their portfolios using futures and options through their brokers or custodians. The fact that we are one of the very few markets in the world with such a large single stock futures (136) market is suggestive of a cash equity cannibilisation feature of our capital markets. I.e. if I can buy Infosys at 10Rs margin in a single stock future easily versus having to pay 1000Rs to buy the underlying stock, it is apparent how investor behavior will be.
    7: Net, net, it is indisputable from data that retail participation in derivatives in India is inordinately high which in itself is substantially larger than cash market volumes. It is also evident that retail derivatives volume is more to take directional bets with margin funding than the need to hedge their portfolio. This, as a public policy choice for India is undesirable is our argument. If someone can argue that high retail participation in speculative derivatives trading is good for the markets and serves a productive economic purpose in our current stage of development, then it will be good to hear that.

    1. The ideology of liberty and individual freedom is precious in and of itself, and should not be cast aside without strong evidence in hand.

  3. There is one fact "retail participation is high in India by world standards". From that it does not follow that there is something wrong with it.

    Here is an example of how such reasoning goes wrong. Let's start with the fact: "Consumption of turmeric (`haldi') in India is high by world standards". Now imagine you make the giant leap and say "There is something wrong with it" and start proposing that the government should ban purchases of haldi by individual households, or tax it, or something of the sort.

    This is not permissible in serious public policy thinking.

    Before you claim that there is something wrong with haldi consumption in India being out of line, you have to show hard evidence that something is going wrong as a consequence.

    The Koreans have that evidence. Now the discussion shifts to the next stage: Do we have some levers in public policy through which something can change.

    That evidence does not exist in India.

    All that we have is:

    1. Retail participation in derivatives in Korea is high by world standards.
    2. The Koreans have hard evidence that this is bad for those individuals. (There is no evidence that it's harmful for society at large).
    3. Retail participation in derivatives in India is high by world standards.

    That's it.

    All you have is these 3 facts.

    To proceed from these 3 facts into suggesting that government do something to reduce retail participation is not logically sound.

  4. This is where public policy differs from academic theorising about ideologies. India didnt wait for its own 9/11 event to then start implementing airport security and baggage screening procedures that slowed down passenger movements in airports considerably and are very inefficient. There was no "hard" evidence to show that lack of stricter security measures in airports in India would lead to plane hijacks. Another example - Michael Bloomberg, who made his fortune on Wall Street that embodies libertarian thought, as Mayor of New York strongly advocated and implemented a rule that said no restaurant can serve more than 16oz of soda to one customer. In New York city, one of the world's richest and educated cities, he didnt think people could exercise their freedom to decide how much soda to drink. Evidently, once in public life, he felt the need to think different from a libertarian Wall St practitioner. Argument here is simple - high retail participation in derivatives indulging in speculative trading driven by margin financing is both economically unproductive (doesnt lead to capital formation) and adverse selective (attracts other speculators). Is there an argument for why this is indeed good for India's economic development, haldi and other constructs aside?

  5. I've been a regular derivatives participant over 6 years now and have never made profit any single year despite constantly being glued to TV and trading systems. I'm reaching a point of no return as my accumulated losses have grown too large. I know many such people from various backgrounds who've gone into Peril through derivatives trading which is almost like an addiction. From my personal experience and that of people I know, I strongly feel that there should be stringent and high eligibility criteria so as to dissuade retail investors from gate crashing into this whirlpool which can potentially make them lose their life savings.


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