CHAPTER 6

EMERGING TRENDS IN EQUITY DERIVATIVES MARKET

IN INDIA

 Index :
6.1 Introduction 250
6.2 Strategic Applications and Key Benefits of Equity Derivatives 253
6.3 Emerging Trends in Indian Equity Derivatives Markets 258
6.4 Problems of Indian Equity Derivatives Markets 273

249
 CHAPTER 6
EMERGING TRENDS IN EQUITY DERIVATIVES MARKET
IN INDIA

6.1 Introduction:
Since 2000, when the equity derivatives market was permitted by SEBI,
there have been several changes in the landscape of equity derivatives trading
in India. It is not only that the global equity derivatives markets have
undergone change but the same were witnessed by the Asia Pacific derivatives
market in general and India in particular. These changes had even greater
impact on the entire capital market or the financial market as a whole. During
this period of last decade, both the exchanges and the brokers have seen
tremendous increase in the number of players and also the exponential growth
in the total volume of equity derivatives trading.
There are two existing equity derivatives exchanges in India offering
contracts in various indices and the single stocks. Since grant of permission for
equity derivatives trading in India, while the derivatives exchanges have tasted
varying degrees of success, the equity derivatives market in India is generally
viewed as very successful. The successful derivatives market depends on
successful exchanges, brokerage houses, other intermediaries and the
participants as a part of overall success.
It is evident from SEBI’s actions that they have been open to new
suggestions and have been more pro-active in accelerating the pace of
development of derivatives trading in India. SEBI has equally supported the
growth of the market by timely regulations and cleared the regulatory hurdles
as and when required to assist the exchanges in encouraging the development of
equity derivatives market in India without compromising on regulatory control
and oversight.
The exchanges have also embraced new technologies and modern and
transparent methods of doing business. The key issue required to be addressed
in setting up effective exchanges is credible corporate governance which starts
with ownership of the exchange. The trend in the international markets is of

250
ownership and access to trading rights on the exchanges to be separate issues.
This is a sea change in the thought process from the original set up of
exchanges where they were required to be association of members as a non-
profit organization. The exchanges are expected to be now set up or seen as for
profit companies.
The process of demutualising all the broker-run exchanges in India
actually started with the Bombay Stock Exchange which was demutualised in
August 2005. Amongst two equity derivatives exchanges namely BSE and
NSE, NSE was already corporatized and demutualised since its inception,
however, BSE was not so. SEBI announced the scheme of The BSE
(Corporatization and Demutualization) Scheme, 2005 on May 20, 2005.
Further, on June 29, 2007, SEBI in the Official Gazette announced that the
Corporatization and Demutualization was achieved. Thus, BSE was
successfully demutualised ensuring a reasonable balance of trading and non-
trading interest.
Further, the management of the exchange needed to be strictly
independent of the brokers and end users. Without this separation, the integrity
of the exchange is questionable and is considered to be hurdle to develop
liquidity. This was also achieved as a result of the demutualization of the stock
exchanges.
The exchanges have made use of internet based technology to best of
the possible way to develop market aggressively for a wide range of potential
participants and users, from domestic traders and financial institutions to
international traders and financial institutions to retail, domestic and
international speculators and to hedge funds and programmed or High
Frequency traders and international individual investors.
The intermediaries in the equity derivatives market also have witnessed
a considerable change over this decade. Especially the broking industry has
undergone through considerable change to service the end users. After laying
down the basics about the net-worth requirement and setting the initial
standards by SEBI, the exchanges had defined minimum standards for brokers
based on capital, expertise and experience and types of activity wished to be
carried out which were stringent than the SEBI prescribed norms.

251
 The Exchanges have been putting thrust on encouraging only the quality
broking entities in the market. The thrust also has been towards
institutionalization of these broking entities or houses. There also has been
large number of international broking houses, either as joint ventures with
domestic brokers or independently who have entered the Indian Capital
markets.
Currently, the equity derivatives exchanges have large number of
brokers associated with them viz. BSE has 903 and NSE has 1309 as on
December 31, 2011. Largely the brokers are trading members and out of these
there are very few who are clearing for themselves or others on NSE and
similarly on BSE.
Besides broking, there are also other intermediaries which have seen the
surge in their activities such as Custodians which were 23 as on March 31,
2012. Also, the Clearing Banks have geared up to meet the settlements by
embracing the technology and they have been using very highly secured
network for the fund movement through internet banking or through FTP
enabling the broking industry to trade hassle free without being bothered about
settlement delays or delays in making margin available. The banking system
has also played important role in fueling the growth of internet trading since the
money transfer could be done online by clients to ensure smooth and
undisrupted trading experience to them.
The clearing corporation has been effectively managing the margin and
collateral requirements and also had been executing the settlements on time.
Their system capacities have gone up to ensure that the systemic risks do not
occur to the market. Clearing corporations also have been able to develop a
good corpus of Trade Guarantee Fund to ensure giving comfort to large foreign
institutional players and Indian financial institutions that it will be able to
guarantee settlement performance of contract through the process of novation.
The broking houses also had to embrace the technology and have been
offering services through various platforms such as internet, low bandwidth
sites, mobile trading, Direct Market Access, Co-location etc. to today’s techno
savvy investors with the advent of technology savvy generation.
Market participants have also evolved over a period of time by moving
away from traditional dealer terminal based trading activity to internet based

252
 trading activity by taking trading reins in their own hands. Retail clients also
now trade through mobile trading and low bandwidth sites of the member
brokers. The clients have also been able to tremendously improve their
knowledge base from complete novice to the derivatives trading to today’s
strategy based trading activities.

6.2 Strategic Applications and Key Benefits of Equity Derivatives:

The investors were handicapped in their investment strategy because of
the non-availability of portfolio hedging facility in India. There was acute need
felt for derivatives, not for generating speculative profits, but for strategic
purposes of controlling risk or restructuring portfolio by the investors.
Exchange traded derivative market helps investors in many different
ways in planning the finances, hedging/mitigating various risks, appropriate
price discovery, arbitrage opportunities, ease of speculations and in many other
ways. Below is a brief explanation given as to what are the strategic
applications, uses and benefits of the equity derivatives market in the Indian
Markets in today’s economic scenario:

A. Edge over Equity Cash Market in terms of operational advantage:

Unlike equity cash market, derivatives market involves lower
transaction costs. They also offer greater liquidity. Large cash market
transactions can often lead to significant price changes. Hence, futures
markets tend to be more liquid than spot markets since large positions can
be taken by an investor by depositing relatively small margins or paying
smaller premiums. Also, larger position in derivatives markets has
relatively less price impact unlike the equity cash market transaction of the
similar magnitude. Also, taking short positions in derivatives markets is
easier than it is to sell short in equity cash market.

B. Provides efficiency to the capital market:

The capital markets become more efficient with the presence of
derivatives markets since the equity cash and equity derivatives markets are
intricately linked with each other. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage and speculative opportunities
quickly and to keep prices in check. Hence, the derivatives market help in

253
 ensuring that the equity prices also reflect the correct prices and restricts
manipulative activities.

C. Helps mitigating the Risk:

Futures and options contract can be very effectively used for
changing the risk of investing in spot market. The derivatives contracts
provide the ability for those with price risk in the underlying item to shift
that risk to a market participant willing to accept it. Exchange traded
derivatives markets help in transferring risk among investors to the ones
who are willing to take such risks. An investor wanting to reduce risk can
transfer some of that risk to other investor who is willing to take more risk.
The risks can be transferred from risk-averse investor to risk taking
investor. Since one can transfer risk exposure using futures and options,
derivatives markets help in raising of the capital. It gives flexibility to
investors to invest in an asset class and then transfer the risk to a level that
is more acceptable to them by using derivatives contracts. Many risks in the
financial markets can be eliminated by diversification. Index derivatives are
special in so far as they can be used by investors to protect themselves from
the one risk in the equity market that cannot be diversified away, i.e. a fall
in the market index. Once investors use index derivatives, they suffer less
when fluctuations in the market index take place.

D. Equitable Price Discovery:

Price discovery is the general process used in determining spot
prices. These prices are dependent upon market conditions affecting supply
and demand. Wherever there is price volatility, there is a potential need felt
for futures and options on futures contracts. In the equity derivatives
market, the price discovery depends on the market’s ability to determine
true equilibrium prices. It is believed that the Futures prices reflect
information about future spot prices and help in disseminating such
information. The precise prices are vital in a free market economy to ensure
proper allocation of resources. The volatility or risk of the underlying asset
is provided by Options markets. Hence, the equity derivatives market helps
in equitable discovery of price for the investors.

254
E. Gives cheaper avenue to Speculators:
Equity derivative markets provide the speculators a cheaper
alternative than the equity cash market to speculate. This is also largely
because of amount of capital required to take similar position in equity
derivatives market is less in this case than the equity cash market. This is
important because facilitation of speculation is critical for ensuring free, fair
and transparent markets. A speculator normally accepts a level of risk only
when the expected returns commensurate with the risk taken. Speculators
normally take calculated risks. Thus equity derivatives market gives
cheaper avenue to them.

F. Benefit to the India’s Financial market system:

India's financial market system will strongly benefit from smoothly
functioning derivatives markets. Internationally, the launch of derivatives
has been associated with substantial improvements in market quality on the
underlying equity market. Liquidity and market efficiency on India's equity
market has not remained so much of a concern since the equity derivatives
commenced trading.
G. Attracts Foreign Investor by comforting:
Foreign investors coming into India get now more comfort since the
hedging vehicles routinely used by them worldwide are available to them
on the Indian shores through equity derivatives exchanges.
H. Development of Human Capital in India:
The launch of derivatives has a logical next step in the development
of human capital in India. Skills in the financial sector have grown
tremendously in the last few years, thanks to the structural changes in the
market, and the economy is now ripe for complex derivatives as the next
area for addition of skills.
I. To reduce the equity exposure in a mutual fund scheme:
The reduction of the equity exposure by Mutual Fund scheme could
have a huge impact on the price of the equity since the mutual fund scheme
typically offloads large quantities in the market. “Such selling results in
depressing the equity prices to the disadvantage of the Scheme and the
whole market. In the event the stock traded is not very liquid, such

255
 offloading may not be achieved speedily and may take some months. Such
offloading is also costly procedure because of brokerage and other
transaction charges applicable in the equity cash market. The same
objective can be achieved by mutual funds or large investor wanting to
offload the stock in the market through index or stock futures at once, at far
less cost and with much less impact on the price of the stock in the cash
market.”1 The scheme or investor would be able to immediately sell index
or stock futures. The actual sale of equity holdings can then be done
gradually by the mutual fund or large investor depending on market
conditions in order to get the best possible prices.

J. To invest in the stocks by the new schemes:

"Typically when a new scheme is floated by mutual funds, the money
raised does not get fully invested for considerable time. Suitable securities at
reasonable prices may not be immediately available in sufficient quantity for
such schemes. Further, when the scheme wants to invest the whole money of
the subscribers, it is likely to jack up the prices of the stocks to the
disadvantage of the scheme and ultimately the unit holders. It is very
important to time the investments in case of equity schemes to ensure better
returns for the unit holders. If the scheme is launched by the mutual funds to
take advantage of low equity prices, such advantage may get lost due to time
taken for raising the funds by the schemes resulting in delay in acquiring
suitable securities as the market situation may change in the interim period.”2
In such event, the availability of stock and index futures and options can help
in providing the value to the unit holders.

K. Helps in redemption of the units by the unit holders in case of open-

ended fund:
“In the case of an open-ended scheme, repurchases can also
sometimes demand liquidation of a part of the portfolio, but then the
schemes face problems in selling each holding in proportion to its weight in
the portfolio is almost impracticable. Further, some of the stocks held by
the schemes may be relatively illiquid and selling pressure may bring the
prices in the equity cash market under pressure and further go down to the
disadvantage of the unit holders. This may also result in realizing the actual
worth of the stocks and may be different from the price used in NAV
256
 computation for repurchase.”3 Largely, the unit holders redeem the units
only when the markets are not good and they are looking for other asset
classes or avenues to invest the money. Hence, the timing of liquidation is
normally not right because of market depression. Stock and Index Futures
help to overcome these problems to the advantage of unit holders.
L. Helps in preserving the value during the stressed market scenario:
Hedging can be potentially used by the Mutual Funds, financial
institutions and foreign investors to protect them against any sudden crash
event in the market. In the scenarios of market crashes, the main worry is
the possibility that the value of the entire equity portfolio will fall
substantially which will also reflect on the performance of the mutual fund.
Thus, sell of Stock and Index Futures and Options can be used effectively
to insure against such risk. Such insurance is specifically important when
the accounts closing date is nearing because the yearly results get affected if
the risk materializes. Thus, by use of Stock and Index Futures and options
such risks can be neutralized.

M. Helps purchases and sell for FII, Sub-accounts and International

investors:
“The buying and selling operations of FIIs cause disproportionate
price-effect on the Indian equities market because there transactions are
normally big sizes and they happen through the cash market only. This is
one of the important factors which make the Indian equities market highly
volatile. The FIIs', sub-account’s and other foreign investors’ buying/selling
is with an intention of either increasing or reducing their exposure to the
Indian equities market.”4 This again in the similar way to the mutual funds
offloading or purchasing can impact the price of the stock in adverse
direction. The availability of stock and index futures in the Indian market
can give them the flexibility to carry out the transaction with greater speed
and less cost and without adding too much to market volatility. As seen in
the past, the FII funds flow show sudden changes from time to time. The
availability of stock and index futures and options gives them and the
Indian investors a hedging device and will also help in increasing the
appetite of the global investors for Indian equities.

257
 N. Helps persons taking Directional trading view
If one has a strong view about any future direction of the market or
the stocks allowed in the equity derivatives trading, the equity derivatives in
the form of indices and stock contracts help them to take the positions on
the exchange traded derivatives market. Also, for example if one has a
strong belief that the interest rates will rise in the near future and wants to
benefit in the future either by taking positions in the index and bank stock
futures or by taking the positions in the index and bank stock options and
benefit them from the falling or rising prices in the time to come. One
would be able to do so by taking positions in the derivatives market.

O. Helps the investors to carry out Calendar Spread Trading

A Calendar Spread, also known as an Inter-delivery Spread. It is the
simultaneous purchase of one delivery month of a given futures contract
and the sale of another delivery month of the same underlying on the same
exchange. This type of spread is called a "calendar spread" because it is
based on different calendar months. For instance, buying a September 2011
contract and simultaneously selling a December 2011 contract. A market
participant can profit (or lose out) as the price difference between the two
contracts widens or narrows. The equity derivatives market helps these
types of investors to carry out such kind of trading.

P. Arbitraging between cash and futures market

Arbitrage is the price difference between the stock and index prices
in underlying cash market and the derivatives market without any view
about the price movement of the underlying. One can earn the risk-less
profit from realizing arbitrage opportunity and entering into the derivatives
contracts traded on the exchanges by initiating offsetting cash. The equity
derivatives market helps these types of investors to carry out the trading
activity. This also helps keep check on the prices of underlying and aligns
the prices to actual level across exchanges and across Indian and offshore
markets where the underlying is traded.

6.3 Emerging Trends in Indian Equity Derivatives Markets:

The global derivatives markets have matured enough now over a period of
time. Indian derivatives market has also undergone a period of immense change.
258
This change also had even greater impact on the industry than the change
witnessed in the equity market segment when they moved from Open outcry
system to the electronic system or when the physical shares were getting converted
into the electronic dematerialized mode of storage through Depositories.
Some of the important changes that the exchanges witnessed during the
last decade included:
1. the emergence of various channels of electronic communications such as
leased lines, internet, mobile platform etc
2. other significant technology related developments such as Direct Market
Access (DMA), Straight Through Processing (STP), Co-locations,
Algorithmic trading, High Frequency trading, internet trading, low
bandwidth sites, mobile trading etc
3. evolution of the systems and processes of the global standards including the
Disaster Recovery Sites (DRS), Business Contingency Plans (BCPs) etc
4. globalization of equity derivatives markets where players now use multiple
products on multiple exchanges;
5. launch of new products by derivatives exchanges to benefit investors.
The above factors also forced the equity derivatives exchanges to:
1. Become demutualised so that the ownership is no longer in the hands of the
brokers but the exchange becomes corporatized exchange
2. Become for profit organizations to be able to raise capital as necessary and
increase the speed of decision making to enable them to face competitive
pressures.
3. Attempt to standardize and bring their operations to the global standards to
cater to a global set of customers including FIIs, Sub-accounts, Foreign
companies or funds and individuals.
4. Compete with each other since the exchanges can now copy the product
immediately without any time lapse and capture the trading volume of the
other exchanges
5. Make alliances or partnerships internally or with the international exchanges in
order to compete more effectively against other exchanges by getting benefit of
the expertise developed by these partners over period of few decades
6. Put in place the systems and processes of the global standards including the
Disaster Recovery Sites (DRS), Business Contingency Plans (BCPs) etc to
ensure that the large institutional players get the comfort of trading on the
Indian Exchanges and also are least bothered about the systemic risks

259
7. Become market friendly to ensure that the lawfully permissible needs of
clients or participants are met and to keep the pace of growth with the
evolution of global and local markets.
These developments have given rise to some interesting trends which
have been penned down below:
A. Rise of screen based trading or internet trading:
The rise of screen based trading, which has given the investors the
ability to access markets directly via their own trading terminals through
brokers or through internet sitting at home or through net cafe, is having a
major impact on how a broking industry operates. The below given table
highlights on the large number trades being carried out now through the
internet trading as per NSE data:
Table 6.1
Year-wise break up of Internet Trading on NSE in Equity Derivatives
Financial No. of Internet Trading Value through internet
Year Trades (Rs. in Cr.)
2001-02 NA NA
2002-03* 201079 5966.66
2003-04 1290043 54601.31
2004-05 4001697 120266.3
2005-06 10109586 428238.85
2006-07 22564037 1214961.31
2007-08 55778800 2372513.81
2008-09 99614694 1685691.67
2009-10 85737750 2624857.52
2010-11 68238474 4169323.55
2011-12 83468213 4910658.92
Source: Compiled from NSE
Note: Data for 2002-03 is available from June 24, 2002 and hence considered since then
for FY

As can be seen from the above table, there has been significant rise
in terminal based and/or internet trading and the clients have started
preferring taking the calls on their own by taking the trading rights in their
hand. This also gives the clients comfort that they may not get cheated by
any dealers. Thus, there has been trend witnessed of increasing use of
screen based trading or internet trading activity by the clients of brokers.

260
B. Reducing Brokerage Rates:
Stock Broking is one among various other businesses in India which
is more technology driven & transparent. The key change is that this has
resulted in execution services becoming very easy. Since there was hardly
any value in providing execution services by brokers, the clients were not
inclined to pay a fee for this. This trend has brought down the broking
charges to pittance. Further, competition has brought down brokerages to
almost 1/100th of the earlier levels. Today, the broking services are offered
to clients at very low cost which is even less than 0.1% of the total traded
value which used to be as high as 1% or more than that during the FY2000-
2001. This also has been eating into the profits of brokers.
C. Providing value added services:
To retain their margins and to compete, brokers have been forced to
provide other add on services such as clearing, execution in global markets,
and more analysis and strategic advice. Also, with the widespread use of
screen based trading systems the brokers are able to offer wide range of
products to their clients. Thus, many brokers have diversified not just into
other exchange products but other related financial products as well.
Clubbed with screen based trading system the usage of internet trading
facilities by the clients has also made it easier for them to go scouting for
the cheaper options available for investment avenues worldwide.
D. Increased competition resulting in margins of brokers coming under
pressure:
With margins more or less continuously under pressure, brokers
have been reducing overheads which largely translate into cutting staff.
This has led to a vicious cycle whereby cutting resources (staff), they offer
fewer services to clients, which in turn reduces margins and, sometimes,
results in fall in brokers’ incomes. However, brokers are downsizing and
cutting costs to remain profitable. This trend was very evident post 2008
crisis faced globally.

E. Focus of large equity derivatives players on Clearing than transaction

The outlook on the global markets and also Indian markets has been
sluggish during various periods in the last decade. Especially, the outlook

261
 was very bearish in 2008 when there were large concerns on the global
economy going into recession. Thus, the volumes on the exchanges and
through the broking firms kept shrinking. Also, there has been increase in
the number of brokers which has also divided the volume amongst those
players. Thus, there has been increasing interest by large brokers on
focusing on their clearing services to generate profits from this sector.
Execution has become less important since even the clients have been
shying away in the sluggish market. Clearing margins is now one of the
major profit sources for many clearing members.
F. Consolidation of Broking Industry:
With the margins under pressure, many derivatives broking entities
are feeling the heat. They also grapple with the thought that they may not be
able to sustain for longer if the global concerns remain and the industry
doesn’t do well. This trend is also seen globally where the industry players
are merging. Equity derivatives brokers who have not been profitable and if
this is a substantial number then these are being sold or merged. In the
Indian Industry, we have seen mergers or acquisitions of some the broking
arms such as Securities Trading Corporation of India (STCI) acquired UTI
Securities, Edelweiss group acquired Anagram group, HSBC acquired
IL&FS Investmart etc to name a few.

G. Large clients going Global:

With the NRI population increasing and also large HNI clients
scouting for more avenues to divest their portfolio, these clients are
becoming more global in their trading outlook. Large players are getting
direct access to the global derivatives markets, via exchange screens and
internet facility and hence have less need for Indian brokers today. Brokers
today need to access other capital markets around the world to offer full
fledged services to retain their larger clients, who are already investing in
the foreign avenues available to them. Further, even retail trading clients
have started feeling the need to diversify in other markets for trading and
require access to global markets. This is also forcing brokers to globalise
their operations in order to provide what their customers want. There has
been tie ups with other global brokers of other futures exchanges taking
place to provide such services to clients.
262
H. Shifting of loyalty from one exchange to other exchange has become
easier
Traditionally, brokers used to be loyal to the exchanges where they
used to participate in the open outcry system. They were also loyal to those
exchanges since they were the members of the association which floated the
exchange and effectively in some form or the other controlled the
exchanges or felt part of the exchanges. Subsequently, with onscreen
markets, a broker can now trade as many products that suit him or the
clients, irrespective of which exchange it is being traded on. Also, with
demutualization the loyalty factor of one exchange has eroded and brokers
have started providing the services to clients as per client’s demands and
depending on their comfort with the exchange. Thus, brokers have much
less loyalty to any one particular exchange now compared to the old days.
I. Reduced loyalty to the Indian Exchanges
Besides, reducing the loyalty to any one Indian Exchange, the trend
is also observed that brokers also have reduced their loyalty to Indian stock
exchanges. Since, the clients and brokers are trading for making profits and
also ensuring that the costs involved in such trading activity are minimal to
increase the profits, they trade on any exchanges where the costs are less
and they are able to generate higher profits. The investors, members and
other participants have no longer remained loyal to any one Indian
Exchange and in order to maximize profits and minimize costs, they are
willing to flock to any part of the world on any exchange which has same or
similar products and which offers them the best or competitive pricing or
deal. “This is also observed from the news articles published in leading
newspapers since January 2012, where it was observed that the Open
Interest in NIFTY Index Futures is higher on Singapore Stock Exchange
(SGX) than that of NSE. NIFTY Index is the index of NSE which got listed
on SGX as well apart from being traded on its own exchange.”5
J. Cross Margining benefit is also effecting the trading in the underlying
SEBI has allowed exchanges to give the cross margining benefits
since May 2008 for institutional clients and since December 2008 to all
categories of clients subject to certain criterions specified by SEBI. This
cross margining benefit is available to clients for trading in Equity market
263
 and the Derivatives markets of the same exchange. It has been observed that
NSE has been controlling almost more than 97.5% of the market share in
the equity derivatives market in India. Also, the margins are levied only for
the derivatives trading and not for the cash equity market trading. We have
seen over a period of time, the underlying market share of NSE going upto
80% and BSE being reduced from around 40% to 20%. One of the reason
may be attributed as cross margining benefit available to clients on NSE
since in order to avail the benefit of the cross margining the clients prefer to
shift their regular equity trading activity from one exchange to other which
can help the clients manage their capital efficiently.

K. Cross Listing of Global Indices

In September 2011, SEBI permitted the exchanges to allow listing
of global indices on the Indian Stock Exchanges for derivatives trading.
There are already various global indices that have got listed on the Indian
Stock exchanges and some of them are also being actively traded on it.
“Globally, since 2010 several exchanges have started offering trading
services allowing domestic investors to trade foreign stock index options
and futures. In 2010, Eurex started offering KOSPI 200 index options. In
October 2011, Honk Kong Exchanges and Clearing, BM&FBOVESPA,
National Stock Exchange of India, Bombay Stock Exchange, Johannesburg
Stock Exchange Micex and RTS decided under an alliance agreement to
cross-list each other’s stock index options and futures contracts.”6 This
trend of cross listing is also gathering momentum and at this stage it is too
early to make any comment on whether they would attract significant
volumes in those indexes.
L. Exchange Corporatization and Demutualization
There has been a trend for exchanges to corporatize and demutualize
and become for profit organizations. This was also forced upon by SEBI on
many exchanges seeing the interference of the broker members in the day to
day activities of the stock exchanges. Under corporatization and
demutualization, the exchanges are run as commercial organizations and not
necessarily in their interest of its former members who were stock brokers.
Today, almost all the recognized stock exchanges are demutualised i.e.

264
 exchanges are not being member owned but rather for profit firms. This has
also paved way for its listing on the other exchanges.

M. Exchanges are increasingly forming alliances

As we see the exchanges are trying to build alliances to get the
benefit of the international expertise and also attract the global players by
comforting them with such alliances. Germany's Deutsche Boerse took 5%
stake in BSE in February 2007. Subsequently, in March 2007, Singapore
Stock Exchange (SGX) picked up 5% stake in BSE. The BSE stake is the
first foreign acquisition by the SGX, which is Asia's third-largest listed
bourse. Earlier, the US-based stock exchange, New York Stock Exchange
(NYSE) had acquired 5% in National Stock Exchange (NSE) in January
2007. We have seen alliances on the Currency Derivatives side where BSE
formed alliance with United Stock Exchange of India Ltd (USEIL) to offer
the currency derivatives segment and suspended its currency derivatives
segment. NSE has also sometime in 2009-10 signed an arrangement
between Madras Stock Exchange (MSE) under which NSE would share
trading platform of NSE with it and the same was also approved in-
principle by SEBI. Looking at the way in which the developments are
happening in the equity derivatives market where one more new player in
the form of MCX-SX getting the permission to provide equity derivatives
trading in India, the scenario of few more such alliances in this space
cannot be ruled out.

N. Changing Structure of the Market Intermediaries:

The old structures of member, membership organization, and
exchanges are disappearing. The centre of a market is no longer the
exchange but the multitude of dealing screens of brokers and end user’s
dealing rooms. Derivatives exchanges are merging or forming alliances due
to increased competition for its survival globally. The trend has been seen
in Currency Derivatives, the same would be seen in the equity derivatives
as well where one exchange is having dominant share in the market and
other negligible. Now, with the entry of the third equity derivatives
exchange, the dynamics may undergo change and may see some changes in
the exchange structures. We are already seeing the changes in the structure

265
 of other market intermediaries where they are increasingly getting into
diversified businesses to keep themselves afloat.

O. Emergence of Technology Based Trading

There have been several developments due to technological
advancements in the way the trading activity is carried out. There is more
thrust on the algorithmic trading by the bigger players and also some of the
small players are also exploring the arbitrage opportunities through the use
of algorithmic trading. There also have been large numbers of global
players with considerable amount of strategies developed around trading in
the algorithmic manner run by the machines without any manual
intervention depending on the market scenario or kicking off of some event
which triggers these strategies. These kind of trades are typically called as
High Frequency Traders (HFTs)
P. Emergence of another mode of trading in the form of Mobile Trading:
SEBI vide its circular dated August 27, 2010 allowed Securities
Trading using Wireless Technology (STWT) or mobile trading.
Subsequently, the exchanges allowed market participants to offer the same
to clients at large. This has not only further given fillip to the existing way
of carrying out trading but also has enabled the large number of mobile
users to trade on the go whether they are travelling, outstation, in the plane
or somewhere in the remote location where mobile connectivity is
available. This is setting a new trend and brining in the set of investors who
can now trade in the market using mobile platform who might have stayed
away from the market earlier.

Q. Direct Market Access to the FIIs, Sub-accounts etc:

Direct Market Access (DMA) is a facility which allows brokers to
offer clients direct access to the exchange trading system through the
broker’s infrastructure without manual intervention by the broker. Some of
the advantages offered by DMA are direct control of clients over orders,
faster execution of client orders, reduced risk of errors associated with
manual order entry, greater transparency, increased liquidity, lower impact
costs for large orders, better audit trails and better use of hedging and
arbitrage opportunities through the use of decision support tools /

266
 algorithms for trading. DMA facility was allowed by SEBI since April
2008. The trading members extend this facility at the location of the FIIs or
sub-accounts as a trading terminal. FIIs/Sub-accounts can place the orders
from these terminals which then pass through the risk management system
of the members before routing them to the exchange’s trading platform.
This facility has been increasingly found to be used by foreign investors.
This has also changed the old trend of receiving the orders through Reuters,
Bloomberg or telephonic conversation setting in the new trend of accessing
market directly by FIIs, Sub-accounts etc.
R. Co-location Facility:
Since August 2009, the Exchanges had introduced co-location
facility for members who were permitted DMA and ALGO trading by the
Exchange. This is another trend getting developed in the derivatives market
where the members take the rack space in the location closest to the
exchange’s trading platform. Today in the world of technological
development, the speed of placing the orders and execution of orders plays
a very important role. It is very important from the members and client’s
perspective that in the scenario of Price Time priority of the trading
platform, they are able to grab the opportunity to execute the trades before
anyone else is able to place the orders for the same. This with the
algorithmic trading is now happening in the fraction of seconds or rather
nano-seconds. Thus, in order to curtail on the order travel time to the
Exchange’s trading platform the brokers and HFT clients have been
wanting to get the space closer to the exchange or in the exchange premises
to route their order earliest to the exchanges. This has been possible with
co-location facility being allowed to them. Today, we find many members
have their operations being carried out from the co-location facility for
large clients and sometimes for their proprietary trading activity.

S. From skilled staff shortage to skilled staff abundance:

Since the day permission was granted to start trading activity in
equity derivatives market in India, it was prerequisite to operate the trading
terminals by certified dealers only. For the purpose, NSE and BSE both had
training department which used to certify such dealers as NCFM and
BCDO certification. In the initial days of equity derivatives trading, there
267
 was dearth of skilled labour since there was good number of brokers in the
market but less number of persons who were NCFM or BCDO certified
who could operate Derivatives trading terminal. Hence, there was a
shortage of experienced staff amongst other brokers and end-users, which
restricted the creation of critical mass of trading in equity derivatives
market. Insufficient training of staff at brokers and exchanges also resulted
in salaries for experienced staff skyrocketing.
However, now the situation has changed, there are good numbers of
certified staff which can handle the trading terminals. Besides this there is
also shift to algorithmic trading by large clients or proprietary books of
brokers and institutional clients. This has also made it redundant to actually
need for manning the terminal even though certified persons certificate is
required for such terminals.
T. Training by Exchanges to Training Institute of SEBI
Even though permission was granted for equity derivatives training,
as mentioned earlier there was dearth of trained staff to operate Equity
Derivatives Terminals. Also, the training was imparted by only two bodies
i.e. NSE and BSE. These exchanges also had limitations in terms of number
of centers at which the trainings could be conducted where as the trading
could be carried out from the nuke and corners of the country. This made it
difficult for many people to undertake the training even if they wished to
take up the same. In the absence of education of these users, a critical mass
of trading volume was difficult to generate since not all potential
participants could have large number of trading terminals due to absence of
skilled and trained workforce. In the derivatives market, the success would
depend on generating critical mass as soon as possible which we have been
able to do now over a period of time.
Over a period of time the number of centers at which the exchanges
conduct trainings also have increased and at the same time SEBI has also
set up its own world class training institute in the name of National Institute
of Securities Markets (NISM) which now conducts trainings in various
courses in the securities market apart from the training in derivatives as
well. National Institute of Securities Markets (NISM) is a public trust,
established by the Securities and Exchange Board of India (SEBI) in late
268
 2004 to add to market quality through educational initiatives. Thus, now
there are 3 entities which are conducting trainings and conducting tests in
the derivatives markets. This has made it easy for staff to undergo training
and today there is no dearth of skilled workforce.

U. From inexperienced industry to experienced industry

In the initial days, even though the exchanges were ready to offer
the trading in the equity derivatives, the technology used was the one
developed by the Indian IT firms. Thus they could not get the expertise of
the international markets. Even though over a period of time, the systems
have proved to be robust, it has taken time for international players to get
the comfort to trade on the Indian Exchanges. The sharing or transfer of
technology and knowledge is critical for the success of any young industry
and in that sense exchange traded derivatives was completely young and
new industry. The globalization of exchanges and brokers also meant that
there would be significant interest by offshore brokers and exchanges
developed in the Indian derivatives market. The derivatives industry could
capitalize on this interest by attracting these brokers and exchanges to our
country only through the comfort given in terms of systems, processes,
economic and regulatory policies. Thus, today after almost over a decade
after the trading started in the equity derivatives market, it has emerged as
one of the successful industry and also now an experienced industry.
V. Doubt of Integrity of the Exchanges to Confidence in Integrity of the
Exchanges:
Since, the exchanges were considered to be broker controlled there
were doubts in the minds of the foreign players about the Exchange
integrity. Exchange staff is usually the staff of the exchange promoters, who
in turn are the dominant traders in the underlying physical markets. The
president or chief executive office of the exchange is usually one of the
dominant players in the physical market. Thus, foreign players shy away
from trading in the derivatives markets due to this situation where possible
conflicts of interest can occur. Thus, in the initial years there was not much
interest developed by foreign players in the Indian derivatives market.
However, over a period of this doubt of integrity has waned. BSE which
was broker controlled, now has become completely demutualised exchange.
269
 SEBI also vide various guidelines ensured that the market players get the
comfort for trading on the Indian Derivatives Exchanges. This was achieved
by guidelines for appointment of the Governing Board of Derivative
Exchanges/Segment including Governing Council/Executive Committee,
Clearing Council, Executive Committee of Derivatives Clearing
House/Clearing Corporation, Chief Executive Officer of Derivatives
Exchange/Segment, Chief Executive Officer of Derivatives Clearing
House/Corporation and Statutory Committees such as Disciplinary Action
Committee, Arbitration Committee, and Defaulters Committee etc.
It has ensured that there are more public representatives or
independent directors on the board of derivatives exchanges, introduced a
more diverse board structure including limiting board members who are
representatives of brokers, introduced committee structures for various
statutory committees such as Arbitration committee, Disciplinary Action
Committee, Defaulters Committees etc. With all these steps taken by the
Exchanges and the regulators, today there is hardly any doubt left for
anyone to doubt the integrity of the exchanges.
W. Emphasis on Infrastructure Development:
In India, the trading system and the clearing corporation/house has
been robust and tasted for long time now. NSE which has been running the
equity market since 1994 has proved time and again that their system is
robust to take care of systemic risk. BSE also has moved to the electronic
platform subsequently. The main requirements for a derivative market are a
trading system and a clearing house. It has been proved that both these
technologies are well developed and available in scalable form. The main
infrastructure challenges are:
a. Having robust surveillance systems to detect market abuses is critical to
give the comfort to the investors at large. This is very difficult to
achieve, but exchanges and SEBI have developed excellent tools for the
same. It is very essential that exchanges are equipped to assure market
integrity to the retail investors in general and institutional in particular
to ensure capital flow in the derivatives market.
b. Effective online margining system to ensure that the market participants
are aware of their margin applicability from time to time. Further, in

270
 order to provide cross margining integration of various systems to assess
margin requirements by considering the securities/derivative positions
jointly. This even though not essential for launching a successful
derivatives market, but this helps in providing substantial cost savings to
participants, especially intermediaries and other active participants.
c. Having robust secured online trading systems to reach to the nuke and
corners of the country and to the world at large since now globe is a
village. This is must since now with the passing time the technology is used
on very large scale to ensure that there is large participation in the market.
d. Today, the equity markets or derivatives markets can be shunned by the
large investors and even the retail investors in general, if there is any
event of natural calamities such as earthquake, flooding etc or terror
attacks that hits the market resulting in discontinuity of the trading
activity or takes longer time in reinstating the trading system. This is
taken care by having putting in place Disaster Recovery Site (DRS) and
Backup Contingency Plan. This is generally achieved by putting DRS at
a place which are in different seismic zones so that the natural
calamities and such other events does not disrupt the market and they
can continue the trading activity despite a particular area or city is hit by
letting the investors in all parts of the world trade unaffectedly.
X. Economic Factors are supporting and fueling growth
The economic factors that help in making the derivatives market
successful are:
a. When there is natural hedging demand in the market, i.e. when good
number of participants in the market has the businesses which requires
them to take exposures.
b. When there are intermediaries in the market who do not have natural
exposures, but take on exposures in the derivatives market. They are
necessary to provide liquidity for natural hedgers. These are
intermediaries who create speculative demand in the market.
c. When there is effective pricing mechanism in the underlying market
which reflects genuine investor demand and is not subject to
manipulation or sudden volatility caused by lack of liquidity.
d. When there is ample of supply of underlying assets.

271
e. When there is thorough knowledge among participants including retail
investors about the functions, possibilities and risks of derivatives.
There is a need for all kind of investors in the market including the
hedgers, speculators and arbitrators. All kinds of demands are must for the
success of the derivatives markets. Considering the nature of Indian market
where “Badla” system has been prevalent since long time, it is relatively
easy to encourage speculative demand on the exchange traded derivatives
market. In fact, all kind of markets have the class of intermediaries whose
prime purpose is trading for the short term and they also keep on increasing
the number of products in their basket for speculative trading.
In India, there has been quite a good growth of Institutional investor
class since very long time and there has been large amount of capital which
has found the investment avenue in the form of equity markets. Further,
after liberalization of the economy there are also a large number of Foreign
Institutional Investors who have been existing in India and have been
investing a significant amount in the equity markets. This has created a
natural demand for hedging due to their business since it requires them to
invest for the long-term and manage their risk in the meantime.
Indian market has been also successful in developing extensive
retail demand in the capital market. This demand is strongly supported by
widespread internet usage which has not only simplified access to the
market but also has tremendously reduced costs to retail clients. In India,
the retail clients also have been providing the investment or hedging
demand for derivatives. It has been observed that most of the time retail
trading is speculative in nature. Hence, there is a need felt for long-term
investment institutions to provide hedging demand which is satisfied by the
financial institutions and FIIs in India. Also, if we look at the number of
contracts traded in the Indian derivatives market it is found that the retail
involvement is strong and has successfully provided the basis on which the
equity derivatives markets are fostering.
Indian Stock Exchanges have transparent and fair trading systems.
Manipulation and abuses are addressed by the legal/regulatory systems to
monitor and investigate breaches. Hence, the other problem such as lack of

272
 liquidity has been addressed through a decent equity market which is highly
liquid.

6.4 Problems of Indian Equity Derivatives Markets:

As seen in our earlier chapters, the government policy with regard to
derivatives market has been assorted. There has been slow progress in opening
up the derivatives market to the Indian investors at large. Even though the pace
of opening up the equity derivatives market has been slow, still there are
concerns on the derivatives in the commodities market. The currency derivatives
market was opened up only in 2008. There are few stumbling blocks in
development of the successful derivatives market. Even though we have
overcome few there are still few barriers in achieving the far greater heights.
1. Statutory / Regulatory barriers
Knowledge of derivatives is not highly advanced in many developing
markets. This is true of practitioners, and is perhaps even more in the case
for regulators. In fact, one of barriers to development of derivatives markets
is cautionary moves/steps by regulators caused by a failure to understand the
nature of derivative markets, or at a minimum to be at ease with their
functioning. That is the precisely the reason for it taking so long in India to
launch the equity derivatives market. Statutory barrier is one of the main
regulatory barriers. There are countries where laws specifically prohibit
derivatives or do not specifically permit them. We have gone through this
phase for long time before the Laws were amended in ….
There are also few nations where laws do not clarify which entity has
regulatory jurisdiction over derivatives even though this is linked to the legal
definition of “securities” and hence the Capital Market Regulatory Body
becomes the regulator for them. However, as we have observed in India, it
took long time for Currency Future derivatives to start since it was falling
under multiple regulators and it was only when the go ahead came for Reserve
Bank of India the Currency Derivatives were launched in India in 2008.
In some countries, laws prohibit gambling or make gambling
contracts unenforceable and hence where derivatives are not clearly
distinguished from gambling, the derivatives market cannot be given go
ahead. Sometimes, the legal framework supports forward contracts where

273
 the norm is physical delivery at the time of expiry but does not support the
cash delivery contracts. However, since most exchange traded contracts are
cash-settled and even if physical delivery is permitted there cannot be
market developed for exchange traded derivatives market. Even though
today, largely these issues have been addressed, it is perceived that the
regulatory body is moving at the snail’s pace in terms of liberalizing the
equity derivatives market and making it accessible to large number of
investors offering bouquet of products to invest or trade in. It has often seen
that the strongest barriers to derivative markets are often government
policies or regulatory inhibitions. Thus, the openness of the government and
the regulatory bodies to quickly comprehend the pace required for the
derivatives and adapt to the quick changes happening in the derivatives
market is primary thing required to give further boost to the existing
derivatives markets. There is a need felt to expedite the regulatory
clearances in order to give further fillip to the growth of the equity
derivatives market in India.

2. Incorrect understanding / pre-conceived notions about the Derivatives

Market leading to cautious approach
Derivatives are considered to be complex product compared to
simple equity cash market trading by many. Many a times, the specific
nature of derivatives markets is not understood by the regulators which
gives rise to many fallacies such as Derivatives substitute the existing
underlying markets, Derivatives only benefit FIIs, Sub-accounts etc,
Derivatives should be with physical delivery to have usefulness etc.
Many times, the decisions by the regulatory authority are driven by
these pre-conceived notions coupled with the fear of taking a decision if
taken in favour of the market may boomerang. Thus, the regulatory body
tends to take a very cautious approach to avoid any controversies and also
to safeguard themselves from any CAG or Parliamentary questions. This
leads to either indecisiveness or putting stringent norms for the market
without having any practical approach but which is rather governed by the
conservative approach. In India, this is predominant where we have seen the
regulators being subjected to the various enquiries and has been answerable
to the parliamentary body. This does not give any independence to the

274
 regulatory bodies to take quick decisions and enforces upon them to take
cautious approach.

3. Apprehensive approach by the Government Bodies and Regulators:

Regulators are normally considered to be risk averse. Financial scams
do not affect only the economy but also goes beyond that to tarnish the
political image and in fact have far bigger impact in the political world
beyond the financial markets. Thus scams leave deep blemishes that can last
for a long time, leaving regulators very cautious and negative towards
innovation. India has seen big scams like Harshad Mehta, Ketan Parekh in
the recent past besides few small scams here and there. These scams have left
the bad taste in the mouth of the regulators and some of them have even bitter
taste as they had to face the music. In fact, most of the scams seen abroad do
not involve derivatives but with the past experience about scams erupting
when the regulations are relaxed little bit and also these scams have most of
the time been attributed to weak regulation rather than anything else.
It is normally assumed that the derivatives market substitutes the
underlying market. It is true and evident from the study that the derivatives
market grow larger than the underlying market but it is also true that the
derivatives market improve and complement the existing underlying
markets by providing other options such as hedging tools, additional
opportunities for speculators and arbitrage opportunities.
It is also feared that due to nature of derivatives products it causes
an exponential upsurge of risks and exposures which may lead to causing
systemic collapse. In practical terms, derivative settlements are very tightly
controlled by a clearing-house by levying margins and also having
settlement of mark-to-market losses on T+1 ensuring that there are no
settlement losses built due to non-collection of margins or losses over a
period of time. In fact, since the regulations of capital adequacy are
stringent and effectively controlled by the exchanges the chances of
derivatives causing systemic risk resulting in collapse of market is minimal.
It is also feared that the derivatives stimulate price speculation
resulting in increased volatility. If we look at the way derivatives offering, it
is an alternative offered at low cost for taking divergent positions. In fact,

275
 derivatives help in reducing speculative volatility and providing liquidity to
the market by managing the imbalances due to lack of liquidity.
All the above factors force government body and the regulators to
be apprehensive about the derivatives markets and in turn affect the
decision making.

4. Increase in Market manipulative activities

Derivatives help manipulators and it make easier to abuse the
market – It is often felt that the derivatives is easy tool used by the market
manipulators to hinder the integrity of the market by one or group of
scrupulous persons/entities. It is very much acknowledged fact that the
derivatives open new possibilities for market abuse, and so present new
challenges for monitoring and surveillance. However, it is not apparent that
markets have successful derivative exchanges are more subject to market
abuse than those that do not. It is easier to regulate markets that are open
and transparent in comparison to unofficial markets for derivatives that
often exist where exchange markets are not available. The regulators also
often feel that the derivatives is a tool which can be used more frequently
and without getting detected for hindering the integrity of the market and
carrying out manipulative activities. Regulators have always feared short-
selling activity and hence there has been ban on short selling from time to
time in the developing Asian markets. The real effect it has is to prevent
profiteering from trading in the bearish markets. The basic structure of
derivatives make such a ban senseless, since selling futures or options gives
the same exposure as short-selling and hence regulators having concerns on
the short-selling are unlikely to vouch for or support derivatives markets.
Thus, the fear always persist about short-selling by use of the derivatives
instruments which has far bigger potential for market manipulation than the
regular trading. Further, various derivatives instruments also have bigger
potential of giving a tool in the hands of the manipulators to manipulate the
market which can also have a cascading effect on the underlying equity
market. Due to dearth of specialized investigative skills the manipulative
activities in the equity derivatives market has so far has not surfaced. If we
look at the investigation orders passed so far, they have been mostly for the
manipulations carried out in the equity market and there have not been

276
 hardly any orders passed against the manipulators in the derivatives market.
Thus, there is need to increased vigilance through highly skilled employees
specifically in the area of derivatives from the regulators and the self
regulatory organizations to give the comfort to the investors in the equity
derivatives market at large.

5. Complexity in the Tax Treatment given to the Equity Derivatives transactions:

Derivatives are fairly new from the concept of application of the tax
treatment. There has always been ambiguity on the tax treatment of the
earnings from transactions in equity derivatives. In the initial years of
derivatives there has been lot of ambiguities in terms of what taxation laws
would be applicable to these types of transactions. In India, the prime
question arises is under which head of income this income would be
taxable. The question also arises on the treatment to be meted out to such
derivatives gains or losses and whether the same should be considered as
business income, capital gains or income from other sources. Also, the
question arises on whether the losses in derivatives should be treated as
speculation losses and whether the income from derivatives transactions
should be calculated when there are unsettled or carried forward derivatives
transactions at the end of the year.
“With regard to the taxation treatment for the trader in the shares, if
the derivatives transactions are merely an extension of the share trading
activity, the derivatives income is regarded as business income and
treatment given is same as that of the share trading income. When it comes
to tax treatment for the income generated by investors in shares who has
also transacted in shares, one has to independently verify the actual nature
of these derivatives transactions. When there are frequent derivatives
transactions which are not linked to the shareholding or the stock
transactions, generally these derivatives transactions are regarded as the
transactions carried out for earning short-term profits and income earned
through these transactions is hence taxable as a business income. However,
when these frequent derivatives transactions are closely linked with stock
investments such as for hedging to safeguard against fall in stock prices of
existing stock investments, then it can be said that these transactions are not
in the nature of business transactions. The issue that remains is about the

277
nature of tax head they would fall in i.e. whether under capital gains or as
income from other sources. Many tax payers take a view that the income
from such derivatives transactions is taxable as capital gains, the chartered
accountants feel that it is possibly a safer approach to treat such income as
income from other sources. In any case, the rate of tax for both these types
of income is the tax slab applicable to the tax payer since these capital gains
are short-term capital gains on securities other than equity shares or units.
Hence, other than for the purpose of setting off of loss, there is no
difference if such income is taxed as capital gains or as income from other
sources. Further, in the event the derivatives transactions are not in the
nature of business then it is attributed to only the loss of a speculation
business which is subject to the prohibition on set off against any other
income. Normally, a transaction for purchase or sale of stocks and shares
which is settled without delivery is regarded as a speculative transaction.
Since derivatives are necessarily cash-settled without delivery by payment
of differences between the initially transacted price and the final price, these
transactions are regarded as speculative transactions. If such transactions
constitute a business, then the loss from such business cannot be set off
against any other type of income.”7
There is a specific exclusion for the exchange traded derivatives in
shares and securities from the definition of speculative transaction.
Derivatives transactions carried out through a registered broker on a
recognized stock exchange are not regarded as speculative transactions. Only
four stock exchanges are so far recognized for this purpose, viz. Bombay
Stock Exchange, National Stock Exchange, since February 25, 2011, United
Stock Exchange and recently in 2012 MCX Stock Exchange is added to the
list. Since, we are covering here only the exchange traded derivatives
market, hence loss from derivatives transactions in securities are generally
not treated as speculation loss, and can be set off against other permissible
incomes, depending on the head of income under which such loss falls.
In case of settled derivatives transactions, the gain or loss is
determined and hence has to be taken into account while computing the tax
payer’s income. In case of unsettled derivatives transactions as at the year

278
end, one is required to book the mark-to-market loss, but ignore any mark-
to-market profit.
To summarize, in Futures since there is no transfer or delivery of the
underlying asset in case of futures, the income or loss from it cannot be
taxed under the head "capital gains". “Hence, depending upon the fact
whether the assessee is a trader or an investor, the head of income, whether
income from business and profession or income from other sources is
determined, but in either case the income will be taxed on net basis at the
rates of tax applicable to the assessee. In case of Options, the option
premium is an income for the writer of the option and a tax-deductible
expense in the hands of the buyer of the option. In case of a trader, the
taxability of the gains on exercise of the option is similar to that in the case
of futures trading. However, in case of an investor, the gain from these
transactions is treated as a capital gain, instead of income from other
sources and the premium is allowed as the cost of acquisition. With the
insertion of Section 43(5) (d), eligible transactions on notified stock
exchanges have been rendered non-speculative in nature. So far only few
exchanges like BSE, NSE, USEIL and MCX-SX have been notified for this
purpose. Therefore, trading in commodity and equity derivatives traded on
stock exchanges other than those mentioned above, is still treated as
speculative, the loss wherefrom cannot be adjusted against any other
sources of income. Also, the losses are eligible to be carried forward only
for a curtailed period of four years. In the event of a situation of the Open
Interest, wherein on the date of the financial year end, there are outstanding
derivatives contracts in the hands of the market participants. Since, under
the prudent accounting principles, derivatives contracts are marked-to-
market (MTM), there can be unrealized MTM gains or losses prevailing as
on March 31st. Whether the assessee will be liable to tax on the gains or
take the benefit of the losses in such a case. Only real income/loss attracts
tax provisions and not the notional gains/losses. However, in certain judicial
decisions notional losses have also been allowed as a deductible expense.
Nevertheless, this is one area which can attract litigative exercise.”8
Thus, even though there has been some clarity on the treatment of
income from the trading in Equity Derivatives still there are few areas

279
 which are ambiguous and they need to be clarified. Besides this, if there are
complex products which would be added to the equity derivatives market
this would create further ambiguity on the tax treatment for such products.
Hence, there should be clarity given by the tax authority in this regard.

6. Transaction Costs on Trades Executed in Derivatives Segment:

Security transactions on the stock markets in India attract various
taxes and charges such as Brokerage, Exchange transaction charges, SEBI
Turnover Fees, Stamp Duty and Securities Transaction Tax (STT). Besides
above charges, service tax is levied not only on the brokerage charged but
also is charged on Exchange Transaction Charges and SEBI Fees. The
structure of transaction costs borne by the investor in equity derivatives
transaction is presented below:
Table 6.2
Transaction Cost Structure – Taxes, levies and Charges
Cost Head Futures Options
STT 51.7% 10.4%
Service Tax on Brokerage 22.5% 75.4%
Stamp Duty (Maharashtra) 12.2% 0.5%
Transaction Charges 11.6% 12.2%
Service Tax on Trx charges and SEBI Fees 1.5% 1.5%
SEBI Turnover Fees 0.6% 0.0%
Source: Contract Notes and NSE
The market participants are more and more finding the multiple
levies and cost of transaction heavy and burdensome. The multiple levies
mentioned above have a cascading effect and adversely affects the
competitiveness of the Indian markets compared to Global markets. There
is a growing concern among market participants that the cost of trading in
securities has been high, causing an adverse impact on the prospects of
Indian Securities market amidst declining volumes on the bourses.
According to market estimates, a securities transaction worth Rs. 1 lakh
currently attracts a total cost of Rs 269, or 27 basis points. This includes
brokerage, stock exchange transaction charges, depository charges, SEBI
turnover fees, Securities Transaction Tax (STT) and stamp duty. Globally,
total cost of transaction is estimated to be in the range of 9 basis points to
30 bps (100 basis points is 1%) of the traded value. With 27 bps, the trading

280
 costs are at the higher end of the range after China and Hong Kong,
according to an IMF paper. However, these countries do not have any
statutory levies as high as in India, especially in the form of STT. It is also
felt by the market intermediaries that high transaction cost has reduced
market depth and liquidity, increased volatility and made Indian markets
less competitive than its global peers.

7. Impact of Securities Transaction Tax (STT):

Government of India, in the Union Budget of 2004-05 introduced
the policy on taxation on securities and introduced the Securities
Transaction Tax (STT). These levies of charges have worked for now
almost eight years and it has been found to be an efficient and transparent
method of tax collection. The rates applicable to different transactions have
undergone periodic changes. Today, STT typically constitutes 52% of the
over-all taxes and levies of a futures transaction. We may draw some
inferences from the Korean markets which offer an interesting insight and
can be considered to be relevant in terms of market size and dynamics
which are somewhat similar to the Indian markets. The Korean markets
were of a similar size in 2003, but currently the Korean volumes are almost
five times the Indian market volumes. This can be attributed to various
factors including a reason that Korea does not have a STT like levy and is
often cited as the reason for the large volumes.

8. Export of Indian Capital Markets to Offshore Exchanges like SGX

Indian markets are increasingly getting integrated with the global
markets. This trend is expected only to gain momentum in the years to
come. For the Indian market players (stock exchanges, market
intermediaries, etc.), this poses new challenges as well as opens up new
opportunities in terms of new products, increased trading volumes, etc. The
scope for growth is vast and the market players are geared up to reap the
benefits of the potential.
“As per the recent news articles published in various financial
newspapers published in the month of November 2012, Nifty volume
growth on SGX has outpaced trading on NSE. Nifty contracts are heavily
traded on SGX with improved volumes and open interest. SGX launched

281
Nifty futures in September 2000, a few months after NSE began that
product on the Exchange.
The report stated that foreign institutional investor exposure to Nifty
futures traded on the Singapore Exchange (SGX) hit a record high in the
month of October 2012 overtaking volumes on the NSE this year which
clearly highlights the continued export of India's financial markets amidst
relative ease of doing business and greater offshore regulatory clarity. The
average daily value of FIIs' open interest (OI), or outstanding positions on
Nifty futures traded on the SGX, was Rs 21,700 crores against Rs 14,600
crores on the NSE in October 2012. This was 60% of the total open interest
on both the SGX and the NSE in value terms, according to data compiled
by financial services company Edelweiss.”9 SGX's OI began rising slowly
after the introduction of the securities transaction tax (STT), a levy imposed
on both buyers and sellers of securities and derivatives, in FY05. The
growth spurted during the temporary ban on P-notes between September
2007 and October 2008. It exceeded that of NSE futures after the
amendment of tax laws in the FY12 Union Budget this March. The
comparison of transaction cost of Nifty Futures on NSE and SGX is given
below in the table:
Table 6.3
Transaction Cost Comparison of Nifty Futures on NSE and SGX
COST HEAD NSE* SGX*
Securities Transaction Cost 17 NIL
Stamp Duty 2 NIL
Service Tax 2.08 0.49
Regulatory Fee .02 NIL
Exchange Fee 1.75 5.12
Total 23.03 5.61
For a round trip transaction 29.06 11.22
* Rs. per lakh turnover
Source: The news article in the Business Line dated January 15, 2012

One reason seems to be lower transaction costs in Singapore

compared with the local markets. For every lakh of turnover (a round-trip
transaction) in Nifty futures, an investor has to shell out Rs 29.06 on the
NSE, against Rs 11.22 at SGX.

282
 More importantly, average open interest on SGX matches or has even
overtaken the average open interest on NSE. Trading on SGX cannot be
explained in terms of time zone differences, as there is a considerable time
overlap between the trading sessions on the exchanges. Feedback indicates
that STT is a powerful deterrent against trading on Indian stock exchanges.
Chart 6.1
SGX Nifty Futures Volume as a percentage of combined NSE & SGX Volume
30%

25%

20%

15%

10%

5%

0%
2008 2009 2010 2011 2012

Source: Edelweiss Research Report

As can be seen from the above table there is a sharp trend of Indian
capital markets getting exported to the offshore Exchanges due to a variety of
reasons. Export of markets means that participants are shifting their trading
positions from the domestic market to an offshore market, where the same
asset is traded, to avail of cheaper taxes and lesser administrative hassles. For
example, STT of Rs 17 per 1 lakh on Nifty futures functions as a tax on
trading, irrespective of whether an investor makes a profit or loss and coupled
with income tax on profits this raises the cost of transaction for an investor.
Thus, FIIs have shifted their trading activity to Singapore Stock Exchange
(SGX) for the same asset traded, i.e. Nifty Futures, which does not impose
STT and even the income tax on the profits made by them is minimal.
Another reason could be attributed to the Government stand taken
earlier on the GAAR proposal which is aimed at retroactively taxing
indirect transfer of Indian assets. This created lot of instability on what
would be the government strategy on taxation and other such issues due to
uncertainty of events. The GAAR proposals now have somewhat thinned in
the air and are likely to be deferred till April 2016 by the Shome Committee
283
 set up to examine the laws. Apart from the uncertainty over tax laws,
market experts attribute the phenomenon to lower cost of doing business
out of the island republic and fewer administrative hassles.
The flight of market overseas will pose adverse long-term threats
and consequences to the Indian Equity Derivatives Markets as stated below:
a. Price discovery may happen abroad
b. Indian regulators ability to monitor and effectively regulate the market
will get diluted
c. Loss of revenue to the Government in terms of STT, Stamp Duty and
Service Tax
d. There will be higher impact cost in the domestic markets on account of
thinner volumes
e. Marginalization of Indian stock exchanges and of the local markets
f. This will also lead to lower levels of transparency

There is already STT revenue loss causing to the Government due to

trading on SGX. The losses in terms of STT revenue are slated only to
increase if the trend acquires momentum. This is a disturbing trend and is to
be fought on different fronts such as providing ease in doing business in
India, effective policy interventions such as transaction cost rationalization,
clarity on taxation and regulatory issues. Indian capital markets are to be
retained within the country’s shores if we were to realize our full economic
potential. Export of Indian capital markets will have significant adverse
consequences if steps are not taken on an urgent basis to reverse the trend.
Hence, there is need for the regulatory body and the Government to act fast
and adopt measures to reverse the trend at the earliest before it s too late to
take any actions. Liquidity creates further liquidity and once the trend gains
momentum and overseas market achieve critical mass in Indian securities it
would be difficult to reverse the trend and will lead to irreparable damage
by permanent export of the Indian markets to offshore exchanges.

9. Problem of Shifting the Equity Derivatives Trading to Commodity Trading

As they say, one problem leads to other and the other to the next one
and may end up having a cascading effect. The problem of excess levy of
charges transaction charges is also seen to be having the effect on the equity
derivatives market internally by facing the competition from the increased

284
trading activity in the commodities trading. This is a trend seen where the
equity derivatives trading activity has been slowly and steadily shifting to the
commodity markets. The shifting trend can be seen from the following chart:
Chart 6.2
Average Daily Commodities and Equities Volume
(Spot and Futures combined) since 2005 (‘000 Cr.)
60

50

40

30

20

10

0
2005 2006 2007 2008 2009 2010 2011 2012

Commodities Equities

Source: Edelweiss Research Report

Commodity trading in India does not attract an equivalent STT.
Commodities Transaction Tax (CTT) was proposed in the commodities
derivatives trading as well, but the plans of the same appear to have been
shelved. The trend is clearly seen of increase in the trading volumes in
Commodities Derivatives in the last five years at the expense of equity
volumes which can be largely attributed to the absence of level playing
field. It is widely believed that the low cost environment of commodity
trading is attracting day traders and jobbers, diluting one vital source of
liquidity in the equity markets.
To conclude, the Government needs to take quick steps to curtail
flow of volumes and in turn liquidity to commodity markets and ensure
growth of the equity derivatives markets in India. Trends, if continued,
would only gather momentum and would be difficult to repair and reverse.
The Government has so far taken a spate of measures to give a fillip to the
economy and the policy pronouncements and other initiatives to boost and
restore the confidence of international as well as Indian investors. In line
with this, there is also a need to suitably rationalize STT.

285
 10. Ambiguity in Applicability and Payment of Stamp Duty in various States:
In India, Stamp Duty is a state subject & since all states have their
own individual Stamp Act, the provisions of respective States Acts is
applicable. Indian Stamp Act applies only in cases where the State Act is
silent on any matter or in Union Territories. The Indian Stamp Act 1899
read with the Indian Stamp Rules 1925 is a Central enactment and the
States have powers to either adopt the Indian Stamp Act 1899 with
amendments to suit the transactions peculiar in each State or enact a
separate Stamp Act for their State. Accordingly, certain States have enacted
a separate Stamp Act i.e. the Bombay Stamp Act, The Kerala Stamp Act etc
whereas other States like Delhi, Punjab, Haryana, Andhra Pradesh etc have
adopted the Indian Stamp Act with suitable amendments.
The provisions of State Stamp Act can be contradictory or different
than Indian Stamp Act as the states are empowered to have their own rules.
For example, in Mumbai, it is governed by the Bombay Stamp Act if the
registered office of the company is in Maharashtra. Hence, the company
will have to follow the provisions of Bombay Stamp Act. As mentioned, the
Stamp Duty rates applicable across all the States in India differ from State
to State. The table below is given to highlight the Stamp Duty applicable in
various States:
Table 6.4
Stamp Duty Rates Applicable across various States and
Union Territories in India
Sr. State / Union Prescribed Rate For every Upper
No. Territory Rs. or part Limit in
thereof Rs.
1 Andhra Pradesh Rs. 0.50 (Fifty Paise) 10,000 50
2 Arunachal Pradesh Rs.3 (Rupees three only) 5,000 None
LAW/LEGN-14/2007of 20-Aug-2007
3 Assam Rs.3 (Rupees three only) vide Act 22 5,000 None
of 2004
4 Bihar Rs.15.00 (Rupee fifteen only) 1,000 200
W.E.F. July 2002
5 Chhattisgarh Delivery 1,00,000 None
Rs. 10.00 (Rupees ten only)
Non-Delivery & F&O
Rs.2.00 (Rupees two only)
6 Goa Rs.1.00 (Rupee one only) 10,000 N.A.

286
7 Gujarat Delivery None
Rs 0.20 (twenty paise only) for
initial Rs. 2,500, then 0.01%
Non-Delivery & F&O 0.002%
Pro-Trade 0.002%
8 Haryana Rs. 0.30 (Thirty paise only) 10,000 30
9 Himachal Pradesh Rs. 0.30 (Thirty paise only) 10,000 30
10 Jammu & Kashmir Rs. 0.60 (Sixty paise only) 2,500 N.A.
11 Jharkhand Rs. 15.00 (Rupee fifteen only) 1,000 200
W.E.F. July 2002
12 Karnataka Delivery 10,000 50
Non-Delivery & F&O
Rs. 1.00 (Rupee one only)
As per amended act of 2010
13 Kerala Delivery None
Rs. 1.00 (Rupee one only) 10,000
Non-Delivery & F&O
Rs. 1.00 (Rupee one only) 50,000
14 Madhya Pradesh Delivery- Rs. 10.00 (Rs ten only) 1,00,000 N.A.
Non-Delivery & F&O
Rs. 2.00 (Rupees two only)
As per amended act of Feb 2006 and
May 2006
15 Maharashtra Delivery 0.01% None
Non-Delivery & F&O 0.002%
Pro-Trade 0.001%
16 Manipur Rs. 3(Rupees three only) vide Act 22 5,000 N.A.
of 2004
17 Meghalaya Rs. 2.00 (Rupees two only) W.E.F. 2,500 N.A.
28-May-1993
18 Mizoram No amendment to Indian Stamp N.A. N.A.
Act, 1899
19 Nagaland Rs. 2.00 (Rupees two only) 5,000 100
20 New Delhi Delivery 10,000 None
Rs. 1.00 (Rupee one only)
Non-Delivery & F&O
Rs. 0.20 (twenty paise only)
21 Orissa Rs. 0.50 (Fifty Paise only) 10,000 42
22 Punjab Rs. 5.00 (Rupees Five only) 10,000
23 Rajasthan Delivery 10,000 None
Rs. 1.00 (Rupee one only)
Non-Delivery & F&O
Rs. 0.20 (twenty paise only)
24 Sikkim No amendment to Indian Stamp N.A. N.A.
Act, 1899
25 Tamil Nadu Rs. 0.15 (Fifteen paise only) 2,500 N.A.
287
26 Tripura N.A. N.A. N.A.
27 Uttar Pradesh Rs. 0.40 (Forty Paisa only) Rs. 20,000 1,000
28 Uttarakhand Rs. 0.40 (Forty Paisa only) Rs. 20,000 1,000
29 West Bengal Rs. 0.50 (Fifty Paisa only) Rs. 5,000 N.A.
Source: Compiled from Stamp Duty Acts of Various States and other sources available as in Mar.2012

Few State Acts like, the Bombay Stamp Act and the Delhi Stamp
Act provide for levy of stamp duty on “record of transaction of securities”
(delivery/non-delivery/futures & options/forward contracts of commodities)
whether electronic or otherwise effected by a trading member through the
association or stock exchange. Apart from few States, there is no specific
article in the other State Stamp Acts for levy of stamp duty on “Record of
Transaction” (Electronic or otherwise) effected by a trading member
through a stock exchange or an association.
Besides, above there has always been ambiguity about which State’s
Stamp Duty Act would be applicable for the transactions carried out for the
clients since the clients reside on various States, the transaction is executed
through a Broker who has his Corporate Office in different State, the
processing of transactions and issuance of contract notes may take place
from third State, the Exchanges are mainly located in Mumbai hence the
State of Maharashtra also is a place involved in the transaction as the
transaction takes place on the Exchange platform. There is so much of
ambiguity for the broker to charge the Stamp Duty due to confusions
created because of activities carried out in various jurisdictions by them. As
mentioned earlier, the rates of Stamp duty leviable on Contract Notes differ
from State to State, however it is learnt that the Government of India plans
to introduce a uniform stamp duty for transactions of all kinds of securities.
The proposed Indian Stamp (Amendment) Bill once approved may provide
an enabling mechanism for a single stamp duty rate for all stock market
transactions.
Thus, there is a need to introduce a unified rate of stamp duty on a
pan-India basis and Government need to expedite the process of amendment
of the Indian Stamp Act at the earliest. Maybe government also ought to
think on withdrawal or substantial reduction in Stamp Duty to keep the
Indian Capital markets competitive in the global environment.

288
11. Inconvenience faced by FIIs doing business in India
“Apart from a trading shift in Nifty futures to SGX, FIIs who are not
allowed to trade currency derivatives on local exchanges like NSE and
MCX-SX access the Dubai Gold & Commodities Exchange (DGCX) to bet
on the rupee versus the dollar. The Indian rupee futures on DGCX
maintained its high-growth trend in the year 2012, rising 101% year-on-
year to reach 859,739 contracts in September 2012.”10
Even though FIIs do not pay any capital gains tax, if it has a
presence in a country with a double taxation avoidance treaty with India, it
has to pay a transaction charge of Rs. 17 per lakh on derivative trades and
also has to hedge the currency risk. The investor also has to file returns and
every remittance made out of India has to be audited by a chartered
accountant. Further, it has to employ a compliance officer to interface with
SEBI besides paying custodian charges when it trades in India.
At the time of scrutiny by tax authority, the tax authority decides
whether the trades executed by FIIs are a case of treaty shopping. Hence,
even for FIIs trading out of countries like Mauritius who don't pay capital
gains tax in India it causes inconvenience. Thus, many FIIs feel that doing
business out of India is not easy and hence so many FIIs have shifted
activity to Singapore.
In Singapore, the tax rate is lower and an FII which creates
substantial employment can even get a tax waiver. Unlike in India, an FII
also saves on currency hedging costs by trading in Singapore where the
contracts are dollar-denominated.
Thus, to summarize FIIs do not get conducive environment to do the
business out of India and also do not draw comfort due to taxation issues
and other unnecessary levies and mandatory requirements.

12. Increasing cost of regulatory compliances:

The intermediaries are constantly feeling the increasing cost of
regulatory compliances. There has been large number of compliance
requirements that has been made applicable since last few years such as
Know Your Client (KYC), In-person Verification, KRA Registration
Requirement, Power of Attorney Requirements, providing the copies of
KYC to all clients, issuing quarterly ledger and demat transaction

289
statements to the clients, Obtaining specific authorizations from client as
separate document, provide policies and procedures of broker to clients,
provide guidance note (Do’s and Don’ts for Investors), Rights and
Obligation, Internet Trading clauses etc to clients, obtain PoA for Running
account facility availed by client with specific authorization, KYC data of
each client to be uploaded with KYC Registration Agencies (KRAs),
obtaining additional information pertaining to Demat account required
including KYC of joint holders, compulsory periodic settlement of
funds/securities – Quarterly/Monthly based on client preference, risk
categorization of client based on AML policy, PAN number verification
with Incme Tax database, Obtaining proofs towards financial details to be
collected from clients opting for F&O, financial details to be collected
periodically from clients, upfront margin collection from clients as
prescribed by exchange based on VAR model, MTM to be collected in cash
on daily basis, exchanges to be informed daily whether these margins have
been collected from all clients, Collateral acceptance and management as
laid down by exchanges, penalty for short collection and non collection of
margin from clients, client order book maintenance in the prescribed
format, framing policy for employee trading, Contract Notes to be issued to
clients within 24 hours of trading day, obtaining acknowledgment copies of
contract notes and preserving Electronic Contract Notes log, showing
statutory levies like service tax, stamp duty, Turn over tax, SEBI fees and
exchange fees separately on contract notes, penalty for even genuine client
code modification for Non Institutional trades, maintaining securities
register detailing shares received from and delivered to the clients in
prescribed format, system to be put in place for not accepting third party
cheques and/or shares, securities received in pay-out on clients’ behalf to be
delivered within 24 hours, money due to the client to be paid within 24
hours of pay-out, client money to be kept in separate omnibus bank account,
inter segment adjustment to be done within same legal entity only after
receiving client consent, not to use one client’s money/securities to meet
other client’s requirements, brokers not to fund client except for margin
trading as stipulated by SEBI, appointing compliance officer and principal
officer by every broker, SEBI certificates to be displayed in the broker

290
premises, notice board of a prescribed size and containing prescribed matter
(Do’s and Don'ts) to be displayed at the entrance of the broker premises,
filing of annual report of a broker every financial year along with net- worth
certificate in prescribed format, prior approvals of SEBI/Exchanges to be
obtained for any changes in MOA/AOA, share-holding pattern, directorship
etc., each client to be sent quarterly statement of securities and funds,
margin register in prescribed form to be maintained, Six monthly internal
audit report to be submitted, 10% of sub-brokers/Branches to be inspected
every year, all Authorized Persons to be inspected by Broker every year,
books to be maintained at segment level, UCC details to be submitted to
exchanges every day, redressal of the Investor grievance within 30 days,
ensuring NISM Series-VII Certification is obtained by various category of
persons of the Stock Broker, yearly submission of system audit report with
SSL certificate and Network diagrams to Exchanges, having Stock Broker
Indemnity Insurance policy, half yearly filing compliance certificate for
Margin facility availed, preventing circulation of Unauthenticated News
through various modes of communications by employees of brokers etc.
The above list is just illustrative. There are many more compliances
which the stock Brokers feel they are burdened with. Besides above, the
broker also undergoes through frequent audits, inspections and also has to
monitor client activities and is responsible for any act by his clients.
Some of these requirements are very much required in order to
protect the interest of the investors and also to ensure that the sanctity of the
market is maintained. However, some are found to be taxing by the brokers
and hence they feel there is burden of compliance. Further, if brokers start
looking at these compliance requirements then they are bound to implement
them on paper but not in spirit thereby defeating the whole purpose of
putting these regulations and compliance requirements in place.
In addition to the high fixed costs, the industry has very low
marginal cost. As a result the cost of adding an additional customer is low
and per transaction costs are limited. Due to this reason, there is a constant
pressure on the brokerage rates. This downward pressure on the brokerage
rates along with lackluster volumes and increased compliance cost has
intensified the competition in the industry and is resulting in consolidation

291
 with the top players. The basic brokerage business is now sometimes a loss
leader. The steps needs to be taken to comfort the broking players by giving
them respite from the continuously increasing compliance costs at the same
time maintaining the sanctity of the markets by the regulators. There is a
need to move from the rule based compliance approach to the principle
based compliance approach.

13. Broking Business plagued with losses leading to small players closing or
selling the businesses
With the persistence of the changed industry dynamics, market
players continuously focus on containing costs, restructuring business
models and relatively larger players with access to capital are exploring
alternate sources of revenue and profits. The last few years have also seen a
more focused attempt by brokerage houses to de-risk business models by
continued diversification into many related as well as unrelated businesses
like commodities broking, currencies broking, commodities and currencies
proprietary trading, capital market financing, mortgage financing and gold
loans. However, the smaller players have not been able to come out of the
bad situation which started taking toll on them since 2008.
It may be noted that the volumes in the Cash market of the exchange
which is a high margin business has come down from Rs. 17,000 crores in
2009-10 to Rs. 14,000 crores in 10-2011 and further came down to Rs.
11,300 crores in 2011-12 on average per day or a decrease of 34% over the
last 2 years. The volumes in the derivatives segment of NSE grew
marginally from average of Rs. 115,000 crores in 2010-11 to Rs. 125,000
crores in 2011-12. However, it is interesting to note that on one side
average derivatives turnover increased marginally by 8.6%, the index
turnover in futures decreased by 18% and stock turnover in futures
decreased by almost 25% from 2010-11 to 2011-12. Most of the growth in
the volume has come from trading in index options which constitute 73% of
the entire derivative turnover recorded on the exchange. It is interesting to
know that the exchange derivatives turnover is computed on contract value,
whereas the income to Broking Company is a % on the premium value
which is significantly lower. Hence, in effect even though the exchange
volumes have increased by 8.6% in the derivative segment last year with a

292
 significant part coming from index options turnover, it has not resulted in
increase in income for broking companies. The options trading, by virtue of
the fact that brokerage is levied only on premium value is a very low margin
business for the brokers. This continuous drop in high yielding cash market
volumes has sharply impacted overall equity brokerage revenue pool.
Some of them are still plagued with the huge losses and sometimes
there is also concern on their existence. That is the reason, we have been
seeing consolidation happening in the broking industry and larger players
are taking over smaller players. Only the scale and diversification has been
able to keep the industry going as the turnover has come down and there is
hardly any income now earned through the broking business.

14. Not having inter-market fungibility of funds/collaterals of the Clients:

As explained earlier, most of the broking entities are diversifying
their activities in various other asset classes. The broking entities are
moving towards becoming the one stop financial solutions. Most of these
entities are offering various other services to their clients such as
Commodity Derivatives, Currency Derivatives, Insurance Broking,
Portfolio Management Services (PMS), Mutual Fund Distribution, Loan
Against Shares (LAS) by Non Banking Financial Services, selling other
financial products such as personal loans, housing loans, car loans, credit
cards, structured products etc. either on their own wherever permitted under
the law or otherwise through their group and associate companies.
For the above purpose, many a times client has multiple touch
points. Also, there are various requirements of funds, collaterals, margins,
obligations at various points of time with various entities. Thus, even
though the client has enough margin money, securities or collateral
available with any entity will not be able to get the exposure on the other
for the want of fungibility of these collaterals/margins available with
various group companies.
For example, a Stock Broking entity cannot become Commodity
Broking entity. Thus, it has to form a subsidiary and obtain the license
separately for the commodity broking. Now, if a client has collateral with
this Commodity broking entity worth Rs. 1 crores lying idle and unutilized
on a particular day. If the client finds a favorable situation in the equity

293
 derivatives market, the client would not be allowed to take the position by
the broker since there are no adequate collaterals/funds in that particular
Stock Broking entity to get that much exposure and provide the margin
money. Thus, this fungibiltiy issue is one of the major hindrances in making
the financial services seamless for the clients. This only ends up causing
inconvenience to the clients.

15. Many Regulatory Bodies for the similar products but different asset
classes:
The above problem of fungibility also can be attributed to the
multiple regulatory bodies for various asset classes. Besides, the above
problem, the derivatives market functions more or less in a similar manner,
what differs in every derivative is the change in the underlying. Somewhere
it is equity stock, somewhere it is commodities, government bonds, foreign
exchange currencies etc the decisions with regard to most of these classes is
taken by the respective regulatory bodies. For example, the decision
pertaining to Commodities trading is taken by Forward Market Commission
(FMC), with regard to securities market the decision is taken by SEBI, with
regard to Foreign Exchange it is taken by RBI and so on. This not only
slows the decision making when the multiple bodies are involved in
decision making, as seen in the case of Currency Futures, which started as
late as in 2008 due to multiple body involvements, but also the experience
or knowledge base gained by one regulator remains with it and the other
regulators may end up committing similar blunder without drawing
anything from the rich experience gained by the other regulator.
For example, SEBI has reach experience of more than two decades
in regulating the securities market and has so far been able to put the
systems and process in place. However, its counterpart in commodities is
considered to be lagging behind and many of the guidelines in the
commodities which are drawing parallel to those already issued in the
securities market long time back are getting issued now.

294
 References:

1. Dr. L. C. Gupta (1998), Report of the Committee on Derivatives, SEBI,

Mumbai, PP21-23
2. Ibid, P22
3. Ibid, P23
4. Ibid, P24
5. BL Research Bureau (Jan 15, 2012), Nifty futures volume in Singapore Soars
30% in 2011, Business Line, Mumbai, PP1-2
6. WFE/IOMA (2012), Derivatives Market Survey 2011, WFE, France, P31
7. Dr. Ajay Kumar & Vivek Dubey (2010), Derivatives trading in India and
Taxing Effects, Taxmann, Mumbai, PP2-20
8. Gautam Nayak (2011), Beyond the Tax Book, Livemint, Mumbai, PP1-2
9. ET Bureau (Nov 05, 2012), FII Position on Singapore Exchange Nifty
outpaces that on NSE, Economic Times, Mumbai, PP1-2
10. Ibid, PP2-3

295