DERIVATIVE UNDERCURRENTS

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By Anand James

Why are stocks continuing to go up, even though macros do not show much to celebrate? This was the question that one of my friends used to bombard me with, every time we met on the weekends. My counter argument was usually that stocks always price future cash flows. He would seem to agree with that temporarily, only to bounce back viciously next week with the same poser. I got some respite in February as the stocks pulled back after Budget. But given how dogged he had been earlier, I knew it was only a matter of time that the stocks turned higher again, and that he would pounce on me with the same nagging question. So, I put the question straight to him, as to why he felt equities are much higher than where he thought they should be.

My guess was right; he had sold his equity investments earlier and was left to rue the missed opportunities. But that wasn’t all. He was struggling to come to peace with the fact that his own business was showing no signs of the growth spurts that the stock indices were supposed to reflect. And it dawned on me that much of his dissent had to do with our long held notion that the equity index is the barometer of economy. Perhaps at some point it may have been, but now, with just 20 percent of Nifty50 index stocks constituting over 55 percent of the index weightage, the barometer argument is not fair, especially as there are over 4600 listed companies and over 10 lakh unlisted companies.

So, what angle should the stock market be viewed from?

Firstly, to the end that no government can be expected to offer pension for all of its 1.3 billion citizens, a thriving and healthy stock market is in the nation’s interest, as an important savings avenue. In addition to that, and equally importantly, a buzzing secondary market, also by default, ensures a good primary market, giving cheaper and easier source of funds to companies. To facilitate these, government and the regulator work towards

  1. ensuring liquidity and depth by having more participants by way of small investors and institutions, both domestic as well as foreign,
  2. ensuring meaning and hedging ability and interconnect across diverse assets like bonds, currencies, stocks, futures, options, commodities, etfs, mutual funds REITs etc. and lastly
  • ensuring a fair playing ground in terms of regulation as well as taxation.

While demonetisation, digitisation and other measures direct or indirect has opened a flood gate of systematic investment in stocks, the ongoing and emerging changes in derivative segment has hardly attracted many discussions, but are sure to, soon. Let us look at some of the recent changes in the derivative segment.

Derivatives: Need for Investor profiling:

Over the years, the derivative volumes have gained significantly in terms of volume as well as popularity. But derivatives is primarily a hedging instrument and those playing with the same without adequate knowledge is infact buying the same risk that the instrument was designed to avoid. Hence SEBI, has been persistent in trying to raise the bar for small investors so that they do not burn their fingers in the speculative pursuits. A timeline of SEBI’s moves in the last few years could throw more light.

  • 2012 – Removes Mini Derivative contracts
  • 2015 – Hiked minimum investment size for derivative products from Rs. 2lk to Rs.5lk.
  • 2017
  • Allows MFs to participate in derivative market.
  • Seeks public comments whether there is a need to make physical settlement mandatory for stock derivatives.
  • SEBI allows options on commodity futures.
  • Allows participation of FPIs in commodity derivatives in IFSC.
  • 2018
  • SEBI looks to increase the minimum investment size further to Rs.10 lakh.
  • Budget exempts transfer of derivatives and certain securities by non-residents from capital gains tax

Single license for equity and commodity brokers

With SEBI giving green signal on September 21st, 2017, equity brokers can now allow their clients to do commodity trading and commodity brokers can permit their clients to do equity trading under single licence.

Benefit to investors:

  • Single account for equity and commodity trades
  • Single KYC
  • Easy switching of funds for equity and commodity trades. Also single account will make it easy for traders to continue with their trading activity in commodities when equity markets close at 3:30 PM while commodity markets continue till 11:30 PM.
  • Possibly margin money may be allowed to be used for equity and commodity positions.

Benefits to brokerages:

  • Ease of maintaining accounts as single KYC required.
  • Reduction in operational cost as now common infrastructure may be used.
  • One-time certificate of registration. Deposit amount, fees, net worth requirement may become more favourable for equity and commodity brokers.
  • Potential cross margining.

Commodity derivatives back in focus

Currently trades done in agri-commodities are considered speculative as they are not charged CTT of 0.01% (sell side). An agri-commodity producer, in order to protect the price risk, takes an opposite position in the derivatives market, he is not allowed to set off the loss arising out of the derivative trades against his business income as derivative trading in agri-commodities is considered speculative and could only be set off against any other speculative income. This was shoving away manufacturers from entering into hedging positions which partly attributed to the low volumes seen in agri-commodity trades on exchanges. In the 2018 Union Budget, FM proposed to provide that trading in agricultural commodity derivatives on a recognized stock exchange shall not be treated as a speculative transaction even if no Commodities Transaction Tax (CTT) has been paid in respect of those derivative transactions. This is a positive move as far as agri-product manufacturers are concerned. Also he proposed to amend Finance Act, 2013 to rationalise levy of Commodities Transaction Tax (CTT) on options in commodity futures. Earlier, options on commodity futures were charged tax similar to STT which required seller to pay 0.05% and if the sold option is exercised then purchaser has to pay 0.125%. Now, from April 1st 2018, on exercise of options, the purchaser has to pay 0.0001% as against 0.125% earlier. This is expected to increase the trading volumes in options as well as futures market. Presently, the agri-commodity futures market account for just a small portion of the total commodity turnover and commodity futures turnover as a whole is insignificant compared to the equity turnover. The 2018-19 budget proposal to amend the existing law and treat agri- commodity futures trading ‘non-speculative’ which along with single licenses is hinting at good times ahead for the commodity derivatives market, especially at a time when commodity prices are on the rise across globe.

So, while the market remains fixated on the LTCG impact presently, the strong under currents of change along derivatives are undeniable, which is likely to make financial markets much deeper and meaningful and also usher in growth along allied segments, especially the lending and borrowing segment for both stocks as well as commodities.

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