Protect, without derivative damage
regulators are flagging risks from heightened trading in derivatives in the Indian equity market. The surge in trading futures and options of listed stocks coincides with rising household exposure to equities, and regulators are approaching the development with investor protection and systemic risk on their mind. Alongside raising awareness among retail investors about the risks involved, new screening mechanisms have been imposed for stocks to qualify for derivatives trading. The effort is directed at restricting derivatives to underlying stocks for which there is sufficient liquidity and trading interest from market participants. There are suggestions for raising transaction costs on derivatives trades. Such a move could, however, affect better regulated institutional investors and reduce the effectiveness of derivatives, hampering market development.
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Key to regulating derivatives is to isolate the hedging intent from speculative intent. Futures and options free capital that needs to be put up as collateral to reduce market risk. The inbuilt leverage also feeds speculative rewards. Rules governing how derivatives can be traded apply to institutions by their potential to cause systemic risk. The concern for Indian regulators is the rising popularity of derivatives trading among retail investors, presumably for speculation and in ignorance of the risks involved. Guard rails must be set up for them against the eventuality of a market crash.
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