The Indian Derivatives Odessey
A distinctive feature of the reforms of the 1990s has been the accent on financial sector reforms. Financial sector reforms in India were brought to the front burner owing to the fixed income and stock market Scam of 1992; this luckily enabled a policy focus in India upon the financial sector well in advance of the East Asian debacle of 1997.
The first three inputs in reforms on the securities markets are now well in place: a new electronic exchange (NSE), reforms to clearing (NSCC) and the depository (NSDL). NSE commenced equities trading in November 1994, the clearing corporation was started in April 1996 and the depository was inaugurated in November 1996. Of these steps, the depository was much delayed and many critics have highlighted the policy failures in these delays. Yet, from November 1994 to November 1996, India's policy makers undeniably achieved a remarkably rapid transformation of securities markets in the country.
Once the basic structures of a cash market fall into place, the logical next step for market development is the commencement of exchange--traded financial derivatives. Derivatives give people the ability to manage and control risk. Today, in India, fluctuations in the stock market or in the dollar--rupee generate a political constituency which seeks government interventions into the market to prevent price fluctuations. This discomfort with price risk is a basic source of the political opposition to liberalisation, which inevitably exposes Indian citizens to greater price risk. Derivatives are hence a central part of the reforms process; by giving individuals and firms the power to make choices about what risks they are comfortable with and what risks are best hedged away, derivatives make individuals and firms more tolerant of price risk and hence liberalisation.
In addition, from a purely financial sector perspective, derivatives are important insofar as they are part and parcel of market development. Derivatives trading helps improve market liquidity, raises skills and knowledge among market players, and is a vital ingredient of market reforms such as the transition to rolling settlement.
Hence the commencement of derivatives trading at an exchange is of utmost important, from the perspective of financial sector development and with respect to the larger problem of creating a constituency for reforms. This step has unfortunately been plagued by delays, and is one where the policy establishment is not shown in good light. In terms of knowledge and capabilities, exchange--traded derivatives could have commenced in India in middle 1996. The story ever since has been one of delays that are reminiscent of pre--reforms India:
- June 1996
- NSE sent a proposal to SEBI about starting exchange--traded derivatives. Time elapsed: 5 months.
- November 1996
- SEBI announced a committee headed by L. C. Gupta to formulate policy for exchange--traded derivatives. This was one of the largest--ever committees of its nature; it had 24 members. Time elapsed: 16 months.
- March 1998
- L. C. Gupta Committee submits report. Five months have passed by since this, with no sign of market commencement in sight.
Through this two--year process, the Bombay Stock Exchange played a prominent role by trying to delay the onset of exchange--traded derivatives while (successfully) working towards rapid regulatory approvals for a new badla. In a comic twist, in recent weeks, the BSE now says that it no longer has any intellectual criticisms of exchange--traded derivatives and wishes to start trading index futures itself.
Earlier, it was thought that a notification from the finance ministry would be all that was needed to enable futures trading. The budget speech, instead, has spoken of an amendment to SCRA. It is hard to see why this clarity was not obtained in 1996 itself, in which case the enabling provisions could have been well in place in advance of SEBI's processes.
In the case of the depository, SEBI had completed its process prior to the legislation being approved by parliament. Hence, it should be possible for SEBI to similarly give NSE all clearances so that the market can commence functioning immediately after the SCRA amendment is passed.
Coincidentally, two changes are bundled into the current amendment to SCRA: the changes which enable exchange--traded derivatives and provisions concerning plantation schemes. It is hard to imagine a greater contrast -- between the basic importance of derivatives for financial sector development and the peripheral role of plantation schemes.
The crucial milestones in the future of institutional development in India's securities markets may now be summarised as:
- Transition to rolling settlement. SEBI should now have a policy through which stock market trading should only be allowed to take place using rolling settlement, starting with the largest stocks in the country and covering all stocks over a period of two years. This process can commence now.
- Onset of index futures and index options. This process can commence the moment the SCRA is amended. Under the best scenario, we can expect to see index futures trading in November 1998 and index options in December 1998.
- Exchange--traded derivatives on interest rates and currencies. The logical next step, once exchange--traded derivatives exist, is to trade derivatives which enable risk management on fluctuations of interest rates and the dollar--rupee. This will be an outcome of the confidence that the RBI has in the quality of NSE's derivatives exchange and SEBI's policy regime governing exchange--traded derivatives.
In the aftermath of the East Asian crisis, it is common for policy makers to express a desire to put problems of financial sector development on a high priority. The policy establishment has set an extremely bad example in the context of derivatives: NSE had invested a great deal of effort and expense in being ready to trade derivatives by middle 1996 and they have been waiting ever since. This is reminiscent of industrial licensing -- through this process, policy--makers are deterring development in other areas.
When an agency or an entity thinks of embarking on market development in the future, they will look at the example of NSE and put a top priority on politics rather than financial sector development. This is reminiscent of the time that Indian industrialists used to spend in Delhi in obtaining permissions, which came at the expense of the time which they should have spent on technology and product development. Policy makers should be supporting innovation and modern market development; they should not be blocking the onset of new ideas.
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