After effects of global financial crisis on Indian derivatives market

-- Narain This paper tries to analyse the impact of global financial crisis on the financial derivatives market in India. It is found that the global financial crisis of 2008 has structurally altered the composition of equity derivatives market in India. The predominance of single stock futures as a derivative product has now been replaced by the predominance of Index option as a favourite derivative product in India. The speculative nature of single stock futures had been the prime reason for the dominance of this derivative product in the pre-crisis period. However, the cautious risk-aversion on the part of the investor has now been the reason for the dominance of Index options in the revised scenario. Such over domination of particular derivative products is not a healthy sign for the derivatives market in India. Keywords: Single Stock Futures, Index Options, National Stock Exchange of India. JEL Classifications: G01, G11, G32

Introduction
The recent global financial crisis of 2008 has been unique in many aspects of its implications for the world financial order. It resulted into collapse of some of the biggest and oldest financial institutions of the world. It made imperative to rewrite the codes of financial exchanges in the world or at least code of ethics and behaviour expected from the big daddies of the financial world. The aftershocks of such Tsunami is still been felt by the world in terms of failures of governments or governance in vulnerable economies. This crisis has incited new perspectives among the theoreticians as well as practitioners of financial theories. This crisis has resulted into structural changes in the way people think and behave with respect to the risk borne by them, particularly the systematic risk. This article tries to present these structural changes observed in Indian stock markets with the advent of global financial crisis. It also tries to comment upon the de-coupling theory of the economists paralleled with India growth story.

Indian Stock Markets

Indian stock market has had a remarkable history of its own. Indian stock market has the oldest stock exchange in Asia (Bombay Stock Exchange (BSE) was established in the year
Assistant Professor, Faculty of Management Studies, University of Delhi.

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1875). It also has technologically advanced stock exchange in world in terms of anonymous order matching system with the introduction of screen based trading mechanism. These exchanges have established a number of milestones in the history of Indian stock market. Indian stock market comprises of 19 recognised stock exchanges which come under the direct regulation of Securities and Exchange Board of India (SEBI). Besides providing spot market for trading in shares, these stock exchanges have also diversified their businesses into the trading of derivatives contracts in stocks and Indices, trading in government and corporate bonds, trading in currency derivatives, Interest rate derivatives, etc. The market structure in each of these segments of their operations has been observed to be oligopolistic in nature, and in some cases, near monopoly exists. In all these segments, National Stock Exchange of India Limited (NSE), a forprofit organisation, has come up as a dominating player in the area of trading in financial securities.

Cash market
As stated above, Indian stock market comprises of 19 recognised stock exchanges for spot trading of shares of the companies listed on these exchanges. Even after the consolidation in the sector of stock exchange operations, most of these stock exchanges are defunct. In terms of the turnover of cash segment, in which shares of the companies are bought and sold by the investors for delivery, the National Stock Exchange of India (NSE) leads with 76.36% share, followed by Bombay Stock Exchange (BSE) with 23.59% share for the year 2010-11 (SEBI Bulletin, April 2011). Therefore, all other recognised stock exchanges in India, i.e. Calcutta Stock Exchange (CSE), Uttar Pradesh Stock Exchange (UPSE), etc., account for less than even half a percentage share among the cash segments of all national and regional exchanges in India. However, the market capitalisation of the NSE was Rs. 67,02,616 crore as on 31st March, 2011 while that of BSE was Rs. 68,39,084 crore.

Corporate debt market

Clearly, there exists a dominance of National Stock Exchange of among the recognised stock exchanges in India in terms of cash segment. However, in terms of the traded value in corporate debt market, NSE comes second with 26% share following to Fixed Income Money Market and Derivatives Association of India (FIMMDA) which holds 68% share in this segment for the year 2010-11. The remaining share, i.e. 6%, is with BSE (SEBI Bulletin, April 2011). For the year 2010-11, there were 31,589 trades with a value of Rs. 4,09,742 crore reported on FIMMDA as

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compared to 8,006 trades with a value of Rs. 1,55,951 crore reported on NSE during the same period. BSE stood third with 4,465 trades with the value of Rs. 39,581 crore during the relevant period. FIMMDA has been experiencing an exponential growth in no. of trades as well as traded value during last three financial years while BSE has experienced an accelerated decline in the no. of trade executed during the same period. NSE has also observed a rise in the traded value of corporate bonds during the same period despite a recent decline in number of trades executed on the exchange (SEBI Bulletin, April 2011).

Currency derivatives market

In terms of the traded value in currency derivatives market, National Stock Exchange comes second with 41% share, following to MCX Stock Exchange Ltd. (MCX-SX) which holds 50% share in this segment for the year 2010-11. The NSE and BSE started trading in currency futures contract from August 29, 2008 and October 1, 2008 respectively. The MCX Stock Exchange Ltd. (MCX-SX) started trading in currency futures contracts from October 7, 2008. From September 2010, United Stock Exchange (USE) also started trading in currency futures contract. The USE has now obtained a third position with 9% share during the financial year 2010-11. For the year 2010-11, there were 90,31,85,639 trades with a value of Rs. 41,94,017 crore reported on MCXSX as compared to 74,96,02,075 trades with a value of Rs. 34,49,788 crore reported on NSE during the same period (SEBI Bulletin, April 2011). Though USE started trading with huge volumes which continued for two months, it succumbed to the financial prowess of the other two players with traded value of Rs. 7,62,501 crore only during the year 2010-11. NSE also invited the wrath of Competition Commissioner of India for its unfair pricing for this segment due to its dominating position in this market. Recently, NSE has also started trading in currency options from October 29, 2010.

Interest rate futures market

The situation is much more skewed in favour of NSE in other segments of stock exchange operations. NSE holds entire market share in terms of the operations of Interest Rate Futures market without any competition. NSE started trading in Interest rate futures contracts from June 24, 2003. However, the product continued to be a laggard primarily due to the way the product was designed and market microstructure. As a result, interest rate futures were re-launched from August 31, 2009 in its new avatar. On its first day of trading, 14,559 trades took place at a total trade value of Rs. 267.31 crore (Indian Securities Market, A Review 2010, NSE). After this

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initial euphoria, this segment has been declining for quite some time. During 2010-11, there were 3,348 trades with a value of Rs. 61.9 crore reported on NSE as compared to 1,60,894 trades with a value of Rs. 2,975 crore in 2009-10 (SEBI Bulletin, April 2011).

Equity derivatives market

National stock exchange also holds 99.9995% share in terms of the turnover of equity derivatives segments for the financial year 2010-11. In this financial year, there were 1,03,42,12,062 equity derivatives contracts traded with a value of Rs. 2,92,48,221 crore reported on NSE as compared to 5,623 contracts traded with a value of Rs. 154 crore reported on BSE during the same period. NSE holds the total 100% market share in terms of the turnover of stock options, stock futures and Index options sub-segments of the equity derivatives segment for the same financial year. The only sub-segment in which BSE holds some amount of turnover (Rs. 154 crore) in this financial year, is the Index futures sub-segment, wherein again NSE captures almost the entire market (SEBI Bulletin, April 2011).

National Stock Exchange of India (NSE)

Preceding paragraphs clearly depicts the dominating role played by the National Stock Exchange of India, rendering it to enjoy monopolistic power in the various segments of stock exchange operations. Currently, NSE has the following major segments of its operations: 1) Equity (Capital Market), 2) Equity Futures & Options, 3) Wholesale Debt Market, 4) Retail Debt Market, 5) Currency Derivatives, 6) Mutual Fund Service System and 7) Securities Lending & Borrowing System. For the financial year 2010-11, the turnovers achieved by NSE in the different segments are depicted in the following chart:

Proportion of segments' turnover in 2010-11 at NSE

0% 9% 10% 2% 0% Capital Market Wholesale Debt Market Ratail Debt Market Equity Derivative Market 79% Currency Derivative Market Interest Rate Derivatives Market

As can also be seen from the above chart, Equity Futures & Options segment accounts for 79.32% share in the total turnover achieved by the NSE during the year 2010-11. This segment was followed by Equity (Capital Market) segment (9.7%) and then by Currency Derivatives segment (9.36%). The other segments have been found contributing negligible amount of turnover during 2010-11. Thus, it becomes interesting to analyse the equity derivatives segment of NSE. This segment is so large that NSE stood 5th largest exchange in the world in terms of number of Futures & Options (F&O) traded in 2010 (Annual Volume Survey 2010 by www.futuresindustry.com) following only to Korea Exchange, CME Group, Eurex and NYSE Euronext. The following table presents the global ranking of National Stock Exchange of India in terms of various parameters.

Global ranking of National Stock Exchange of India (NSE) with parameters

Global rank 2nd 2nd 2nd 4th 4th 4th 4th Ranking parameter Number of Index options contracts traded in 2010 Number of currency derivatives contracts traded in 2010 Number of currency futures contracts traded in 2010 Number of single stock futures contracts traded in 2010 Number of Index futures contracts traded in 2010 Number of currency options contracts traded in 2010 Number of trades in equity shares via electronic order book (EOB) in 2010

4th 5th 9th 9th 10th 10th 12th 14th 14th 16th 16th 16th 19th 21st 24th 24th 27th 30th 49th

Number of mutual funds listed at the end of 2010 Number of futures & options contracts traded in 2010 Domestic equity market capitalisation in 2010 Value of bonds listed at the end of 2010 Number of listed companies in 2010 Investment flows new capital raised by newly listed companies in IPO in 2010 Number of Exchange Traded Funds traded in 2010 Domestic market-capitalisation to GDP ratio in 2010 Value of bonds traded in 2010 Number of single stock options contracts traded in 2010 Number of long term Interest Rate Futures contracts traded in 2010 Value of share trading (electronic order booking) in 2010 Number of Electronic Traded Funds listed at the end of 2010 Number of shares traded in 2010 Turnover velocity of domestic shares Trading value of ETFs in 2010 Number of trades in mutual funds in 2010 Trade value of mutual funds in 2010 Average value of trades (electronic order booking) in 2010

Source: Compiled from WFE annual reports & statistics, 2010 and FIA annual volume survey, 2010

Equity Derivatives Market segment of NSE

The equity derivatives segment of NSE is composed of four sub-segments, viz. 1) Index Futures, 2) Stock Futures, 3) Index Options and 4) Stock Options. A futures contract is a highly standardised contract, traded on a futures exchange, to purchase or sell a specific security at a certain date in the future, at a specified price. The specific future date is known as settlement date. The specified price is known as the futures price and the actual price of the security on the settlement date is called the settlement price. If this security is an equity share then it is called as Stock Futures and if this security is an Index then it is called as Index Futures. However, an option contract is a highly standardised contract, traded on an exchange, entrusting the buyer of the contract an option to purchase or sell a specific security at/till a certain date in the future, at a specified price. The specific future date is known as settlement date. The specified price is known as the exercise price and the amount of money paid by such buyer to the seller of the contract is called as premium. If this security is an equity share then it is called as Stock Option and if this security is an Index then it is called as Index Option. If the option is to be exercised

only on a certain date, then such option is called as European option and if it can be exercised anytime till a certain date, then such option is called as American option. For the financial year 2010-11, Index Options contracts have contributed maximum towards the turnover of equity derivatives segment of NSE. It holds 62.8% share in the total derivatives turnover of the exchange for the year 2010-11. The second largest contributory is the Stock Futures sub-segment with 18.8% share followed by Index Futures sub-segment with 14.9% and Stock Options sub-segment with the remaining 3.5% share. It is also interesting to compare this distribution of turnover to the distribution observed before the onset of global financial crisis. The following charts present the contrasting picture of the two scenarios prevailing before and after the global financial crisis i.e. 2007-08 and 2010-11.
Turnover share at market peak (2007-08)
Stock Options 3% Index Options 10% Index Futures 29%

Turnover share after crisis (2010-11)

Stock Options 3% Index Futures 15%

Stock Futures 58%

Index Options 63%

Stock Futures 19%

Source: Compiled from www.nseindia.com

The comparison of above two charts shows that immediately before the onset of global financial crisis, the equity derivatives market at NSE was having a preference for Individual share based derivatives product which has now been changed to Index based products. Another fact very much evident from the above comparison is that the equity derivatives market at NSE was having a strong preference for Futures contracts which has now been tilted towards Options contracts. A more temporal analysis of this chronological phenomenon is presented in the following table.

Relative shares of equity derivative products (in percentages)

Years Index Futures Index Options Stock Futures Stock Options

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

100 21.08 9.99 26.02 30.32 31.38 34.52 29.19 32.42 22.27 14.90

3.69 2.10 2.48 4.79 7.02 10.77 10.41 33.89 45.45 62.79

50.54 65.14 61.29 58.27 57.87 52.08 57.66 31.60 29.41 18.79

24.69 22.76 10.19 6.63 3.74 2.63 2.74 2.08 2.87 3.52

Source: compiled from www.nseindia.com

Percentage share of equity derivative products

120 100 80 60 100 40 20 0 2000-01 2001-02 4 21 2 10 2002-03 51 65 2 26 2003-04 5 30 7 31 61 58 58 52 58 34 11 10 29 2007-08 32 0 25 23 32 29

10

4 19

45

63

35

22 2009-10

15 2010-11

2004-05

2005-06

2006-07

Index Futures

Index Options

Stock Futures

Stock Options

As can be observed from the Table above, initially, Index future had been capturing all the derivatives markets due to non-availability of other derivative products. Later, gradual introduction of other derivative products resulted into the re-distribution of market share.

2008-09

However, stock futures gained considerable market share (50%) within four months of its introduction, followed by stock options contracts. These stock options were of American style which are now been offered in European style with effect from October 28, 2010. Since then, the market share of stock options contracts has been on a continuous fall and that of Index options has been on a continuous rise. These Index options are of European style. The market share of Index futures in total turnover of derivatives segment has been relatively choppy over the decade. In summary, like developed markets, there has been a general decline in the stock based derivatives and a general rise in the Index based derivatives products. The trend is drifting towards the Index options in recent years. On June 24, 2010, Index options recorded an unprecedented daily volume of Rs. 89,049 crore as well as highest number of open interest on contract expiry. Resultantly, in the year 2010-11, Index Futures has acquired a significant position in the derivatives segment of NSE even in terms of number of contracts traded. This may reflect the growing maturity of the derivatives markets of the NSE.

Pre-crisis Scene: Dominance of Stock Futures

There existed a dominance of Single Stock Futures in Indian stock market in the pre-crisis period of derivatives trading. This dominance has also brought global second position to NSE in terms of number of contracts traded for the year 2009 following only to NYSE Liffe Europe with marginal difference between the two positions. NSE received Financial Derivative Exchange of the year Award by Asian Banker in April 2010. This top position has now been slipped to the fourth place in the year 2010 in terms of number of contracts traded (2010 Annual Report & Statistics, world federation of exchanges). The trading in single stock futures in India did achieved the position of top product traded on Indian bourses. It was due to merely speculative nature of this instrument, as a substitute for another erstwhile prevalent speculative arrangement known as carry forward or Badla system. The Badla system was not exactly the forward trading arrangement rather it allowed transactions on a spot basis, but the settlement was carried forward under some regulatory measures like carry-over & daily margins, position limits, price ranges, etc. Although, Badla system led to a stupendous growth of the market in all parameters like number of investors, turnover, etc., the market regulator banned the system presumably because it led to excessive speculation and/or its misuse.

The powerful Badla lobby strongly opposed the introduction of stock futures in Indian markets, as Badla would lose its sheen. Following the 2001 fall-off after dot-com bubble burst, the bull phase of Indian stock markets came to an end with the advent of stock market scam coupled with a bank scam. As a result, Indian capital market moved into the state of depression. In less than a year, the dominating Badla system was abolished and compulsory rolling settlement was imposed. A positive result of all these incidents was that the derivatives finally started growing rapidly. SEBI also started putting emphasis on the introduction of more exchange traded derivative instruments. June 2000 saw the introduction of Index futures in India. Because of the depressing state of the Indian stock market, many market participants accused SEBI of failing in revamping the capital market. The brokers complained that they had lost their bread and butter. Luckily, SEBI took the decision of introducing more derivative instruments. In the month of June 2001 European styled Index options were introduced in India. This was further followed by cash settled American styled stock options in 31 securities in the month of July 2001. The trading was still not picking up at that time. However, trading got a fillip once NSE introduced cash settled stock futures on November 9, 2001 before Diwali, on the same 31 individual stocks in which stock options were being traded with the approval of SEBI. Although, Dr. L. C. Gupta Committee on Derivatives (1998) has not explicitly recommended the introduction of single stock futures but these were introduced as a result of strong lobbying by the broker community to satisfy their demand for a replaced speculative instrument. As single stock futures possess most of the traits of Badla, market participants whole heartedly welcomed their introduction. The trading in these product opened bigger horizon for new business opportunities. In fact, within days of their inception, the trading in stock futures surpassed trading in other available derivative products and eventually the cash segment of NSE. Single Stock Futures trading has grown exponentially not only in the context of Indian derivatives market but also in terms of its global trade ranking. Stock Futures offers various advantages to the investors which have contributed to the growth of this sub-segment of equity derivatives segment of NSE. As opposed to the Index Futures, Stock Futures are lucrative to form risk free profitable arbitrage opportunities because the underlying asset is available for trading in the cash market. Some other advantages offered by these instruments are:

1) Potential for leveraging: An investor who wants to take a position in a futures contract need not put up the entire amount of the investment. Instead, the exchanges require only the Initial Margin to be put up when taking position in the futures contract. Merely this fact makes the futures contract a leveraged derivative product. The degree of leverage provided by the futures market equals 1/(margin rate). This degree of leverage available in the futures market varies from one contract to another because of the variation in the Initial Margin requirement of different contracts. In this way, a stock futures contract reduces the capital constraint problem. 2) Cost efficient than options: When compared with the stock options, the cost of futures contract is the opportunity cost of the funds tied up in the form of margins with exchanges. These margins are adjustable at the time of final settlement of the futures contracts. Whereas, options involve premium which has to be paid up-front. It is an explicit charge to be made compulsorily. Over a short period of investment, the comparative advantage goes in favour of stock futures. It helps investors in creating costeffective hedging strategies. 3) Avoiding short-sale restriction: An investor by taking sell position in the futures market can avoid the constraint on short selling the security in the cash market. It is also beneficial for the investor to take this route as it is more economical and less restrictive as to the number of contracts with short position. This ensures that the price discovery process become swifter in responding to the new information. 4) Supplements other derivative products: While Index-based products are used for investment or hedging, stock-based products cater to the stock specific risk of certain stocks which constitute the existing index or fund investments. It adds to the degree of market completeness. Due to these compelling factors & features, the turnover of stock futures sub-segment surpassed the total turnover of the entire cash segment of NSE in the third year of their introduction itself. On November 1, 2007 stock futures contracts set an unprecedented record of daily turnover of Rs. 71,195 crore. However, the relative share of stock futures at NSE has been observing a decline, both in terms of the percentage of the numbers of contracts traded and percentage share of stock futures turnover in total turnover. The world financial crisis of 2008 has proved to be a structural change in the growth path of the stock futures contracts. Though, the turnover has

picked up since then but there is fall in the absolute number of contracts traded. The relative percentage shares are still declining. It was only after the outbreak of the global financial crisis that the continuous rise in the absolute number of SSF contracts was reverted back. The temporary disenchantment of the investors from the single stock futures trading was only due to the ill-effects of the futures trading misfired on account of global meltdown. Single stock futures have successfully strived to attain its previous level of contracts traded but it is also getting a tough competition from Index futures contracts in terms of number of contracts traded. NSE has notched to third position in the world during first half of 2011 in terms of stock futures as well as Index futures contracts traded (WFE, market highlights for first half of 2011). Meanwhile, Index option has attained an infallible position in terms of number of contracts traded which requires another structural shock to dislocate from its current height. The following table presents the description of the two derivative products in terms of number of contracts traded as well as turnover achieved in their respective sub-segments.

Business growth in selected derivative products

Number of contracts traded Years Stock futures Index option Turnover in Rs. crore Stock futures Index options 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 1,957,856 10,676,843 32,368,842 47,043,066 80,905,493 104,955,401 203,587,952 221,577,980 145,591,240 186,041,459 175,900 442,241 1,732,414 3,293,558 12,935,116 25,157,438 55,366,038 212,088,444 341,379,523 650,638,557 51,515 286,533 1,305,939 1,484,056 2,791,697 3,830,967 7,548,563 3,479,642 5,195,247 5,495,757 3,765 9,246 52,816 121,943 338,469 791,906 1,362,111 3,731,502 8,027,964 18,365,366

Source: www.nseindia.com

Post-crisis Scene: Dominance of Index Options

In the post-crisis scenario, the National Stock Exchange of India (NSE) has observed an unprecedented dominance of Index Option contracts. This new dominance has also brought global second position to NSE in terms of number of contracts traded for the year 2010 following only to Korean Exchange (2010 Annual Report & Statistics, world federation of exchanges). During the first half of 2011, Index option has conquered 70.92% share in the turnover of derivative segment of NSE followed by Stock futures (13.64%) and Index futures (12.72%) subsegments (www.nseindia.com). This much share of a single derivative product is unprecedented in the history of equity derivatives market in India. This dominance is associated with the following factors observed for as the derivative products: 1) Hedging downside risk: With the help of option strategies, downside risk of losing money invested by the investors can be limited to the option premium paid especially when the market behaves in the choppy manner as observed during the global financial crisis. 2) Diversification by the Index: When the market is volatile, as observed during the global financial crisis, investors refrain from taking additional risk on their investment. Making investment in share based products will expose them with firm-specific risk over and above the market risk borne by them. Thus, by making investment in Index based product helps them to reduce the firm-specific risks by adequate diversification.
3) Redistribution effect: The recent policy changes announced by the market regulators

have also contributed to the lethargy of single stock futures to attain its previous glorious position. SEBI has made a path for the exchanges to introduce physical settlement in stock based derivative products in line with other developed derivatives markets. Recently, NSE has also introduced stock options with European style. These developments have contributed to the re-distribution of derivative turnover.
4) Revision in tax treatment: With effect from 1st June, 2008, one major change in the

taxability of options contracts were noticed. From this day, the value of the transaction relating to an option in securities for the purpose of levying securities transaction taxes (STT) were shifted to the option premium amount (for seller, and settlement price for buyer) from the earlier basis of aggregate of the strike price & option premium (only for

seller) applicable hitherto. This resulted into the improvement in the profit margin of the option seller.

Conclusion
The global financial crisis has proved to be a structural break in the financial derivative segment of Indian stock market. As has been reflected by the analysis, the turnover structure of National Stock Exchange of India, the exchange with dominating position in India, has shown that the derivatives trading has been a substantial & significant component of Indian stock market. Within this segment, the investors have been spotted with their obsession with Single Stock Futures contracts in the pre global financial crisis period. This obsession has now been altered in the post-crisis period. However, the obsession is now with the Index Option contracts. However, with such preference for Index based derivative products, studies focusing on the interaction of derivatives trading with spot market on aspects of lead-lag relationship, impact on liquidity, transfer of trading, etc. can now be justified to come up with robust conclusions. Such studies have been inconclusive so far in Indian contexts. Nevertheless, such a skewed preference is not desirable situation for an emerging economy like India. A reasonable mix of the derivative products should provide a better alternative to the investors by supplementing the avenues for investment and risk management with the growing maturity of Indias derivatives market.

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