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S. Vaidya Nathan

A MORE robust futures and options market (FOM) may be the long-term effect of the liberalised risk containment measures, eligibility norms for stock futures and options, and position limits announced by Securities and Exchange Board of India. The changes also reflect the regulator's confidence in the functioning of the FOM on the National Stock Exchange over the past four years. If they lead to an improvement in the linkage between the FOM and the spot market, that would be significant. The linkage has, so far, been conspicuous by its absence, except in the homestretch to the contract expiration date, every month. The BSE's bid to comeback into the fray through the proposed weekly option contracts may also benefit, if SEBI gives the green signal.

Entry norms: The value of the order size for a stock to qualify for stock futures has been reduced from Rs 5 lakh to Rs 1 lakh. This should make several stocks eligible. As always, the underlying stock must figure in the top 500 in terms of market capitalisation and traded value over the preceding six months. A new requirement of a market-wide position limit of at least Rs 50 crore will, however, guard against unbridled expansion in the trading list.

Implication: Investors and traders will have more hedging and speculative options in the FOM if the NSE sheds its reluctance to add to the existing list of about 50 stocks. If the list is expanded, some of the speculative activity could shift from the spot market to the futures market. The expansion is likely to confined to large-cap stocks and a few mid-cap stocks.

Index futures: There are only two indices on which futures are available now: Nifty and the CNX IT Index. Futures contracts can now be introduced on any index if, at least, 80 per cent of it is made up of stocks that would qualify for stock futures; a stock that is not eligible should not account for more than 5 per cent of the index market capitalisation.

Implication: This may have a limited effect and one can expect index futures on the CNX Banking and CNX Oil & Gas Indices. The Nifty Junior and CNX Mid-Cap would not be eligible, unless there is a swift expansion in the list of stocks for futures and options. The revised regulatory framework would also not permit a futures contract on the S & P CNX 500. SEBI should consider relaxing the eligibility norms for such broad-based indices.

Limits for FIIs: There is a five-fold rise in the limit available for the FIIs to trade in index futures and options. They would now have separate limits of Rs 250 crore in these two segments, unlike the combined limit of Rs 100 crore earlier. The FIIs can also take short positions equivalent to the value of their stock holdings; long positions can be built up to the extent of investments in debt.

Implication: The FIIs can become more dominant players in the FOM domain; they now account for about 20 per cent of the turnover. They now have complete flexibility to hedge their equity portfolio and also take up contracts outside of their stock exposures.

They are likely to take more short-trading calls, which coupled with similar action by other market players, have the potential to enhance intra-day volatility. The changes have enhanced the relative attractiveness of the Indian market for the FIIs.

Higher position limit: The market-wide position limit for stock futures and options has been doubled. It can now be 30 times the average number of shares traded or 20 per cent of the free float (a company's equity less shares owned by promoters). The higher of the two will be the limit.

Implication: There is now space for a higher level of open positions, which could encourage trading. Stocks, such as Wipro and TCS, which are due to be listed, may benefit by the doubling of the multiple on the free float.

Seamless open interest: One of the more significant changes is the removal of the linkage between open interest and price/volatility ranges. If open interest reaches 80 per cent of the market-wide limit now, margins increase. This forces traders to cut positions; it also pushes up volatility, without any linkage to views about future price trends. This restriction has been removed.

Implication: Positions can now be built up without any concerns about higher transaction costs regardless of the level of open interest. Artificial jerks in volatility levels would be avoided.

Higher trading limits: Trading members' limit has been increased by 150 per cent to Rs 250 crore, separately for index option and index futures. Limits for interest rate derivatives have also been enhanced.

Implication: Coupled with the enhanced market-wide position limit, this change ensures that traders would have greater latitude in the FOM. This has the potential to enhance depth, liquidity and price discovery in the FOM.

If activity is concentrated on the top 10 stocks and is marked by more proprietary trades, the effect of liberal limits may, however, be lost.

Margin payment/levels: Traders have more flexibility in deciding on when they could pay the market margin and settlement margin. Minimum initial margins for stock futures and minimum charge for stock option will also be scaled up for stocks with an impact cost (the effect on price of buy and sell orders of a prescribed size) of more than 1 per cent.

Implication: Traders have leeway in planning payment for margin calls; they would not be required to cough up higher initial margins to cover for potential losses due to delays in the payment of market margin.

The higher initial margins may skew trading activity more in favour of the more actively traded stocks as higher liquidity in them would ensure that impact cost stays checked at less than the prescribed limit.

Liquid assets: Trading members are required to maintain liquid assets as a quasi-capital adequacy requirement. This has two components: Cash equivalents and securities. Investments in gilt and money market funds will now qualify for the former, and equities and other mutual fund investments for the latter.

Implication: The change enables members to use their investment portfolio more effectively and reduces the level of funds needed to bankroll commitments on liquid assets. Members can also earn a few percentage points more on funds that are tied to the obligation to maintain liquid assets.

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